Legal update Iran: new petroleum sector opportunities March 2016 Energy Oil and gas The announcement last month by Foreign Affairs Minister Stéphane Dion lifting most of the sanctions restricting Canadian entities from participating in oil and gas activities in Iran has generated a great deal of discussion in Canada s oil and gas industry. The implementation of these changes on February 5 was widely welcomed by both the Canadian, and the international, oil and gas industry. With oil prices near their lowest point in the last decade, the world s energy industry has been watching Iran, with its low finding and development (F&D) costs, very closely. This update examines the effect of recent changes to Canadian sanctions laws, reviews the anticipated terms of the long-awaited Iran Petroleum Contract (the IPC) and provides recommendations for both service companies and E&P companies that are interested in examining opportunities in Iran. Note that while the amendments have significantly eased sanctions against Iran, in line with the EU s amendments, it is important to remember there are still strict US sanctions against Iran that could affect business if a company has an affiliate in the US. Background With oil production dating back to the infamous D Arcy Concession of 1901, (in which William D Arcy obtained a 60- year concession over more than one million square kilometers of Persia in exchange for 20,000), Iran has long been a central figure on the world s international petroleum stage. Although the numbers vary widely, the most recent figures issued out of Tehran estimate Iran s proven reserves in excess of 150 billion barrels, placing Iran amongst global leaders. More importantly in today s pricing environment, however, is the fact the National Iranian Oil Company (the NIOC) estimates F&D costs as low as US$10 to US$16/barrel. Canadian sanctions Following the hostage crisis of 1979 the United States and later the United Nations, Canada and the European Union, imposed a series of sanctions on Iran. These have been amended and refined over the past 30 years, but prohibitions preventing Canadian companies and persons from becoming involved in the Iranian oil and gas industry have been a part of Canada s sanctions law for years.
PAGE 2 On February 5, 2016, Canada amended its Special Economic Measures (Iran) Regulations in recognition of progress being made by Iran under the Joint Comprehensive Plan of Action. Of significance for this update, these amendments now permit the Canadian oil and gas industry to resume some activities in Iran. As of February 5, 2016, the general embargo on Canadian imports from Iran and Canadian exports into Iran has been lifted. Of importance to the Canadian energy sector, the prohibition against transferring, providing, or disclosing technical data to Iran or to any person in Iran that is required for specific applications, including producing petrochemicals, and transporting crude oil or petroleum or petroleum substances, has been lifted. Similarly the prohibition against drilling and mineral surveying and exploration has also been lifted. Finally, the prohibitions against providing financial or other services to Iran or a person in Iran in respect of the import, purchase, acquisition or shipment of natural gas, crude oil, petroleum or petrochemical products, have been removed. There are still certain exceptions after the general embargo was lifted. There remains a prohibition on sales or shipment of goods listed in Schedule 2 of the regulations, as well as the prohibition against transferring, providing, or disclosing technical data in relation to goods listed in Schedule 2. (Schedule 2 is a list of 41 goods with a description of each.) There is a range of goods included in the list, such as autoclaves, HEPA filters, high-speed cameras, riot gear, and certain precious metals. Note that not all sanctions have been lifted and certain individuals, industries and entities still remain subject to sanctions. Consult counsel with the specifics of your proposal to be certain the planned activities are permitted. The Iran Petroleum Contract The lifting of sanctions coincides nicely with the introduction of Iran s new petroleum law regime. As part of the move to attract foreign investment into the Iranian petroleum industry, the Oil Contracts Restructuring Committee of the NIOC s planning department was tasked with developing a new form of host government contract that would attract foreign investment, assist in developing the Iranian petroleum industry, and address many of the concerns voiced over the buyback contracts issued by/entered by Iran for the past several decades. The official IPC text has not yet been released, although the key provisions were publicly disclosed at an energy summit held in Tehran in November of 2015. The public release of the IPC, together with a series of presentations from Iranian officials, was first scheduled for London in early 2014, but has been rescheduled a number of times with the most recent cancellation being announced in February 2016. The event has been adjourned once again with no date yet announced. The IPC s key provisions were approved by President Rouhani s administration on September 30, 2015. Notwithstanding the absence of a formal release of the text, based upon the information released at the Tehran Summit, (and the various briefings, public interviews, speeches by government representatives and news releases over the past two years), and armed with a combination of market intelligence and industry speculation, it is now possible to develop a reasonable sense as to what the IPC will likely include or provide. Key themes running throughout this intelligence include the state s desire to attract significant foreign investment, (some reports indicate that as much as US$180 billion is required over the first five years), foreign equipment and bestin-class technology. Iran seeks to increase production to in excess of 5.5 MMb/day by 2020. The following is a list of 10 key considerations for those interested in the IPC. Objectives of the IPC. Since early 2014 the Oil Contracts Restructuring Committee has held periodic briefings in order to outline the IPC s key objectives and obtain feedback from stakeholders. These presentations revealed that the IPC was being designed to resolve a number of industry concerns with respect to the pre-existing Iranian buyback model. Specifically, the new IPC
PAGE 3 will: (i) incorporate internationally recognized oil and gas concepts wherever possible; (ii) provide investors with a more fairly balanced risk-reward allocation; (iii) provide enhanced fiscal incentives for challenging operations; (iv) provide the investor with a greater voice throughout the production phase; (v) encourage a more complete, and an earlier, transfer of leading technologies; and (vi) promote the accelerated development of the Iranian oil and gas industry through partnerships, training and local content obligations. Structure. The usual starting point for an analysis of a host government contract is to place the agreement into one of the four customary categories: (i) production-sharing agreements; (ii) service contracts; (iii) concessions; or (iv) some form of hybrid arrangement. Based on the information publicly available at present, the IPC is best described as a modified service contract, (a form of hybrid agreement), with a number of fundamental changes designed to address the shortcomings of the old buyback model. Under the old model, a master development plan was required, which would set out a ceiling for capex, detail the cost recovery period, and set the rate of return. There was very little flexibility to deal with unanticipated costs. Both the development phase (two to four years) and the production phase (five to 10 years) were very short. Under the new IPC the NIOC will be a signatory to the agreement, acting on behalf of the Islamic Republic of Iran. The counterparty will be the contractor, which must be a joint venture with an Iranian partner, utilizing either an incorporated entity (a joint venture company) or an unincorporated joint venture. Early publications out of Tehran spoke of a joint venture company being used, but it is not yet clear whether an unincorporated joint venture will be permitted. The Iranian partner in the joint venture must hold at least a 51% interest. To date, there is no indication as to whether the Iranian entity must be selected from a pre-approved list of partners. One of the key themes that runs throughout the various government announcements is the importance of respecting the Islamic Constitution of 1979 and its provisions that all hydrocarbons belong to the nation and no arrangement inconsistent with that provision will be permitted. The IPC has been designed to be consistent with these restrictions while at the same time allowing investors to incorporate revenues generated from operations into their financial reporting. To date, there is very little information on how this is expected to be achieved other than confirmation that the IPC will permit the transfer of ownership in the hydrocarbons from the state to the investor at a specified delivery point. The issue of title to resources continues to be a contentious matter in Iran with protesters arguing that the IPC improperly circumvents these constitutional prohibitions. The IPC will be structured to provide for different rights, decision making, and compensation, during each of the exploration, development, and production phases, with a further set of special conditions and incentives for enhanced oil recovery operations. During the exploration and appraisal phase the contractor will act as operator until the commencement of production. Once the project enters the development and production phase, a new entity, the joint operating company, is to be established with operatorship being transferred to the new entity. A work plan and budget is to be prepared and approved each year by the joint operating company. This is much more attractive than the limited flexibility formerly in place under the buyback contracts, which provided very little relief for unforeseen costs or overruns. The IPC will also seek to make marketing of oil and gas attractive to investors, recognizing that it will be very difficult for Iran to recapture lost market share and seeking to draw on the marketing expertise of the international IOCs. Term. The IPC terms will be significantly longer than the previous buyback contract. Presently, the terms are expected to be divided into: (i) an exploration and appraisal period ( four years with a potential two-year extension) and (ii) a
PAGE 4 development and production period ( 20 years with a potential five-year extension). This is a significant improvement over the short terms ( 10 to 12 years) permitted under the old buyback model. Incentives and Remuneration. The IPC is very clear that a primary focus for the new structure is the encouragement of specified activities. For example, small fields, enhanced oil recovery projects, brownfield projects and geologically challenging reservoirs will result in higher remuneration. Operations in the southern fields, (with relatively less complex geology and less demanding operating conditions), will provide for lower compensation while challenging operations, (such as in the central desert or the Caspian Sea), will be rewarded with higher compensation rates. Although the complete details of the fiscal terms have not been released, compensation will be indexed to production on a fee-per-barrel basis. Capital costs incurred prior to production are amortized over a period of five to seven years from the date of first production, with an extension possible with the NIOC s approval if the contractor has been unable to recover all amortized costs. An R factor will be used to calculate remuneration on a fee-per-barrel basis with variables being indexed to production, price and costs. Priority Fields. The most current information available indicates the majority of the fields that will be posted by the NIOC will be located near neighbouring countries, and will be a mix of oil fields ( 55%) and gas ( 45%). Fields bordering Iraq, Qatar, Saudi Arabia, Kuwait and the UAE (described as the joint fields ) feature prominently in the most recent government publications. Facilities. In addition to encouraging E&P activities, the NIOC has also designed a program to encourage investment into infrastructure, with assistance being sought in constructing a terminal and tank farm at Jask, constructing a pipeline from Goreh to Bushehr, developing an oil terminal near Bahregan, and with a series of smaller gas projects. Tender. The NIOC will be named as the contracting party under the IPC, acting on behalf of the Islamic Republic of Iran. Contracts will be issued for locations identified by the NIOC and will be awarded through a tender process. Title to petroleum must remain with the state (in accordance with the Constitution) with costs of production being cost recovered from oil and gas produced. Reports are inconsistent as to whether there will be a cap on cost oil, although the most recent reports indicate that cost recovery will be capped at 50%. Title to Assets. The IPC will provide that title to facilities will transfer to the state, although it is not yet clear whether transfer will occur at the time of import, as costs are recovered, or at the expiration of the term. Local Content. In addition to the 51% interest required in the joint venture, there will be customary local content requirements with respect to local suppliers and service providers. The details of these requirements have not yet been announced but are, as is customary, expected to be higher during the production phase.
PAGE 5 Disputes, Sovereign Immunity and Stabilization. There is contradictory intelligence available on this point. Although early releases from the Oil Contracts Restructuring Committee contemplated using expert determination for resolving financial and technical disputes, and using international arbitration for resolving all other issues, these proposals appear to have been rejected as most of the recent information suggests the IPC will be governed by the laws of Iran and disputes must be resolved before Iranian courts. This continues to concern international investors and, while government officials acknowledge these concerns, there is no clear indication that international arbitration is being considered. Similarly, there does not appear to be any indication that a waiver of sovereign immunity will be provided by the IPC or that there will be any stabilization provisions. Conclusions Even though the IPC s release has been an on-again-off-again event for the better part of two years, the IPC continues to generate a great deal of interest around the globe. With world-class reserves, some of the lowest F&D costs available today, and the prospects of entering a region that has been closed for decades, the international oil and gas industry will watch eagerly as final arrangements are made this spring for the public presentation of the IPC. E&P companies (both the majors and the independents), along with service companies and professional advisors, are readying themselves for this day. Thomas Valentine For further information, please contact one of the following lawyers: > Wayne W. Fedun Calgary +1 403.267.9414 wayne.fedun@nortonrosefulbright.com > Ryan W. Keays Calgary +1 403.267.9523 ryan.keays@nortonrosefulbright.com > Trent J. Mercier Calgary +1 403.267.9435 trent.mercier@nortonrosefulbright.com > Thomas E. Valentine Calgary +1 403.267.8154 tom.valentine@nortonrosefulbright.com Norton Rose Fulbright Canada LLP, Norton Rose Fulbright LLP, Norton Rose Fulbright Australia, Norton Rose Fulbright South Africa Inc and Norton Rose Fulbright US LLP are separate legal entities and all of them are members of Norton Rose Fulbright Verein, a Swiss verein. Norton Rose Fulbright Verein helps coordinate the activities of the members but does not itself provide legal services to clients. References to Norton Rose Fulbright, the law firm, and legal practice are to one or more of the Norton Rose Fulbright members or to one of their respective affiliates (together Norton Rose Fulbright entity/entities ). No individual who is a member, partner, shareholder, director, employee or consultant of, in or to any Norton Rose Fulbright entity (whether or not such individual is described as a partner ) accepts or assumes responsibility, or has any liability, to any person in respect of this communication. Any reference to a partner or director is to a member, employee or consultant with equivalent standing and qualifications of the relevant Norton Rose Fulbright entity. The purpose of this communication is to provide general information of a legal nature. It does not contain a full analysis of the law nor does it constitute an opinion of any Norton Rose Fulbright entity on the points of law discussed. You must take specific legal advice on any particular matter which concerns you. If you require any advice or further information, please speak to your usual contact at Norton Rose Fulbright. Norton Rose Fulbright Canada LLP 2016