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Tehran's Oil Dysfunction

Author: Lionel Beehner
February 16, 2007

Introduction

Iran’s energy sector is slowly collapsing under the weight of subsidized gas prices and poor development of its aging oil fields, according to a number of Western economists. Despite boasting the world’s second-largest oil reserves after Saudi Arabia, Iran has resorted to rationing its gasoline. As global energy prices slide downward, some analysts predict Iran’s economy, already suffering from UN sanctions, could take a big hit that will have important political ramifications. One economist even predicts Iranian energy exports could dwindle to zero by 2015 without a sufficient influx of outside investment. Iran says it has taken some steps to spur investment, such as striking energy deals with countries like Pakistan and China, but it has proven unwilling to cut gas subsidies and curb its domestic appetite for energy.  

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How important is energy to Iranís economy?

Sales of oil and natural gas account for the bulk—between two-thirds and three-quarters—of Iran’s government income and make up roughly 80 percent of its exports. Ten percent of the world’s proven oil reserves lie in Iran. But as production (around four million barrels per day) has slid in recent years, supply has not caught up to demand. Spurred on by artificially low energy prices, Iranians are among the world’s largest consumers of gasoline. The population of sixty-eight million, which has doubled since 1979, is growing by around five hundred thousand annually, meaning for the foreseeable future production is unlikely to keep pace with domestic energy demands. Thus, Iran, despite its vast reserves, must import roughly one-third of its petroleum. The International Energy Agency estimates $165 billion in investment will be required for Iran to meet its energy production goals set for 2030.

How dire are the problems in Iranís energy sector?

Iranian officials point to oil revenues expected to reach $50 billion this year and Iran’s vast foreign currency reserves (roughly $60 billion) as signs of a healthy economy. Gholam-Reza Nozari, Iran’s deputy minister of oil, predicts Iran holds enough oil reserves to last seventy years. But economists remain doubtful of Iran’s economic health. Roger Stern of Johns Hopkins University says that last year Iran for the first time dipped into its foreign exchange reserves, instead of its rainy-day stabilization fund, to offset shortfalls attributable to falling oil revenues. He projects that oil exports could plummet to zero by 2015 without a significant spike in investment or dip in domestic

Beginning in March, Iranians will be mandated to ration their gasoline.

consumption, both unlikely scenarios. “Virtually all revenue growth has been applied to pet projects, loss-making industries, etc.,” he wrote in a recent paper on the topic in the Proceedings of the National Academy of Sciences. Even Iran’s oil minister, Kazem Vaziri-Hamaneh, announced last September that production could fall by 13 percent annually unless there is a surge of investment. The result has been a flattening of Iranian oil exports. Tehran has consistently failed to meet quotas set by the Organization of Petroleum Exporting Countries (OPEC), largely due to the damage its refining capacity sustained during the Iran-Iraq War but also because of the government’s refusal to invest in its aging oil fields. Economists estimate Iran’s dilapidated infrastructure results in millions of barrels lost in production each year.

What is the status of Iranís economy?

Even with high global oil prices, Iran’s economy has remained weak. It suffers from high inflation, double-digit unemployment, and per capita income levels 25 percent lower than those enjoyed under the Shah in the 1970s, according to Arnon Gutfeld of Tel Aviv University. The World Bank calculates that, given its growing labor force and demographic strains, the economy needs to produce seven hundred thousand new jobs annually to absorb these new entrants into the labor force. UN Security Council sanctions, imposed last December, bar exports to Iran that could be used for nuclear purposes. Washington’s efforts to block foreign banks from dealing with Iranian financial institutions have served to squeeze Iran’s economy. But Akbar E. Torbat of California State University says compared to its Middle Eastern neighbors, Iran’s economy is not faring all that badly. After all, annual growth hovers around 5 percent to 6 percent and the economy boasts a current account surplus (that is, it exports more goods and services than it imports). He says unemployment figures (officially 10 percent but probably closer to 30 percent) are on par with the region. 

What effect would lower global energy prices have on Iranís economy?

It’s unclear. Michelle Billig, director of political risk at PIRA Energy Group, tells the Wall Street Journal that “[f]ifty-dollar oil doesn’t put [Iran] in any grave danger. After all, it was only a few years ago that we were talking about an oil windfall for [Iran] at $30 a barrel.” Yet other experts warn that falling oil prices could wreak havoc on Iran’s economy and possibly require Tehran to dip further into its foreign exchange reserves or seek loans from Russia or China. The government of President Mahmoud

Experts warn that falling oil prices could wreak havoc on Iran’s economy and possibly require Tehran to dip into its foreign exchange reserves or seek loans from Russia or China.

Ahmadinejad relies heavily on high global energy prices to underwrite his vast social programs and populist-minded subsidies (gasoline, bread, heating oil). His latest budget, which boosts government spending by 20 percent, contains over three hundred such social programs, including affordable housing and job retraining initiatives.Tehran spends between $20 billion and $30 billion per year, or 15 percent of Iranian gross domestic product, on heating oil and energy subsidies, according to Market Oracle, a UK-based firm that analyzes financial markets. Last summer, fifty Iranian academics sent an open letter to the president criticizing his inefficient system of subsidies.

What steps has the government taken to address its energy woes?

Tehran has taken several steps to avert an energy crisis. Among them:

  • Reduce “dependency on oil revenue.” Ahmadinejad recently made this announcement in response to Saudi Arabia’s recent decision to drop oil prices to around $50 a barrel. Ostensibly the move was meant to boost the global economy, which in turn spurs demand for their oil, but Iranians suspect it was aimed at undermining their economy. “We assume our enemies want to damage us by decreasing the price of oil,” Ahmadinejad said in a recent speech. Ahead of Iran’s next fiscal year, which begins in March, the government’s budget provides for a lowball estimate of oil prices at below $30 a barrel, versus the actual $50 price, to account for an “extraordinary incident” (i.e. a U.S. or Israeli military strike) that might further depress oil prices. 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.
  • Reduce domestic consumption. Beginning in March, Iranians will be required to ration their gasoline. Reports from the provinces indicate such a program is already underway. An earlier push to ration gasoline last summer was shelved amid fears of a public backlash and objections from conservatives in Iran’s Majlis (parliament). It’s unclear how severe the rationingplan will be but it will include so-called “smart cards,” a digital system whereby consumers get an allotment that the card automatically deducts from at the pump. The aim of this austerity measure is to keep domestic prices stable, while reducing consumption of gasoline and diesel products, which has soared because of the population spike and subsidized prices. Abbas William Samii of the Center for Naval Analyses, writing in the Weekly Standard, says the UN Security Council sanctions are primarily behind this move.
  • Sign energy deals with eastern neighbors. In September, Iran signed apipeline deal with Kazakhstan worth $3.5 billion and followed it up with a November energy deal with China worth some $100 billion. The China deal would provide annual exports of around ten million tons of natural gas over the next twenty-five years and guarantee China’s state oil company various exploration and drilling rights. Most recently, Beijing and Tehran signed a $3.6 billion deal to develop Iran’s South Pars gas field. The deals reflect China’s desperate need for energy but also Iran’s desire for greater cooperation with its eastern neighbors. Iran recently became an observer at the Shanghai Cooperation Organization, a regional security alliance spearheaded by Russia and China. Finally, Iran intends to sign a $7 billion pipeline deal with India and Pakistan by June 2007, though some analysts are skeptical Iran will be able to deliver on the deal without major reforms to its energy sector.   
  • Establish a mini-OPEC. Earlier this year, Iran floated the idea of forming a smaller version of OPEC, together with Russia and Qatar. The attractiveness of the plan: It would give states like Russia and Iran greater control over international energy prices. The group would also strengthen economic ties between Russia and Iran, which together hold half the world’s proven natural gas reserves. The Kremlin called the proposal “an interesting idea” but stressed it was not in favor of joining a price-fixing cartel.
Who makes decisions on Iranís energy policy?

Decisions related to oil and natural gas are made by the oil ministry, in conjunction with the president and Iran’s parliamentary energy committee. Because of energy’s role in Iranian foreign policy, other committees, including parliament’s national security and foreign policy committees, also weigh in on energy matters. And the managing directors of Iran’s state-run energy companies can influence Iranian energy policy. On Iran’s nuclear energy program, decisions are primarily dictated by the Supreme Leader via his chief nuclear negotiator, Ali Larijani. Because of the government’s many strands and sometimes contradictory viewpoints on energy matters, experts point to policy gridlock inTehran. “Decision making is diffuse,” says Johns Hopkins’ Stern, creating “tensions” between Iran’s various branches of power. Larijani, for example, often corrects—or at least, tempers—statements made by Ahmadinejad related to Iran’s nuclear program.

How does Iranís nuclear program factor into the equation?

On one hand, the declining oil sector supports Iran’s claim that it needs alternative energies like nuclear power for civilian electricity-generating purposes. “The allure of nuclear power to a regime in such straits is obvious,” Stern writes. Nuclear power, some analysts say, would allow Iran to offset its lower production levels and boost its exports of oil and gas. “They might say, ‘We better jumpstart the nuclear program if the oil program is going down the tubes,” says CFR Fellow Charles D. Ferguson. On the other hand, Iran’s nuclear program, which many Western countries suspect is meant to develop atomic weapons, has resulted in UN Security Council sanctions and financial pressure from Washington that has deterred European banks from investing in Iranian businesses with atomic energy ties. To bridge the gap, Iran has reportedly even enlisted the help of North Korea.

What do Iranís energy problems mean for U.S. foreign policy?

Stern suggests a military strike or stronger sanctions may be counterproductive, given the current environment. Instead, he favors an economic attack that would help lower the global price of oil by reducing foreign demand through fuel-efficient technologies, consumption taxes, or other means. Others say Iran’s weak economy provides diplomatic leverage for Washington to deal with Tehran directly on issues like its nuclear program or its interference in Iraq. Then there is the theory, advanced by some hard-liners within the U.S. and Israeli governments, that Iran’s ability to wage the so-called “oil weapon” response to a military strike—i.e. cutting off oil exports or shutting down the Strait of Hormuz—may be jeopardized because of its weak economy. Proponents of this theory argue it is wiser to confront Iran sooner rather than later, when its economy might be stronger.

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