The Economic Consequences of Peace: Winners and Losers from Iranian Reintegration

The exchange of “commodities of mutual intelligence,” reads a 1561 letter from Queen Elizabeth I to Shah Mohammad I, is ordained by “the goodness of the almighty God.” The purposes of English merchants in Persia, Elizabeth informs her Iranian counterpart, are “grounded upon an honest intent, to establish trade of merchandise with your subjects, and other strangers trafficking in your realms.”

Nearly half a millennium later, Europeans are once more flocking to the markets of Iran. Among European investors, there is talk that the removal of nuclear-related sanctions on Iran could herald “the return of the largest economy to the global system since the breakup of the USSR in 1991.” Iran boasts the world’s second largest reserves of natural gas and its fourth largest reserves of oil, with crude accounting for 68% of Iran’s exports in 2013 ($33.1bn). With a relatively mature and diversified $400bn economy – the second largest in the region after Saudi Arabia’s – and a well-educated population of close to 80 million, Iran has understandably proven to be a major attraction for European firms faced with anaemic growth in their home markets. Indeed, as noted by the Economist Intelligence Unit, “[p]rior to the imposition of UN sanctions on Iran from 2006 – and their ramping up from 2012 – Iran was a key market for European countries (especially Italy and Germany) and a major destination for European investment”.

Iranian President Hassan Rouhani’s tour of Europe last January, the first by an Iranian president in nearly two decades, saw the cleric and former diplomat put pen to paper on memorandums of understanding (MoUs) and business agreements with a number of European companies. Iran’s transportation sector is set to be a major beneficiary of Mr. Rouhani’s European business deals, worth a total of €50 billion. Iran’s purchase of 118 planes from Airbus, including 12 “Superjumbo” A380s, at a total cost of $25 billion will go some way to fulfilling the government’s stated desire of modernizing its ageing commercial airline fleet. Agreements worth billions of dollars were also signed with French and Italian firms to build and operate new terminals at airports across Iran, while Italy’s Itinera has agreed to team up with various Iranian construction firms to commence major development of the country’s railway infrastructure. French carmaker Peugeot-Citroen announced that it invested to invest €400 million over the next five years in developing facilities in Iran, which had been the company’s second largest market. Another French automaker, Renault, “has sought to leverage the $560 [million] of its cash that had been trapped in the country … to step up its investment”, while “the presence of Fiat Chrysler’s chief executive, Sergio Marchianne, at a dinner with Mr [Rouhani] on January 25^th raised speculation about the possibility of Fiat also building an automotive production facility in Iran.” A 2015 World Bank report estimates that Iran’s auto industry accounts for 10% of the country’s GDP, and increased European investment in Iranian auto manufacturing should provide a major boost to what is already “one of the main job-creating sectors” in the country.

European finance has also begun to trickle back into the Islamic Republic. As observed by the Wall Street Journal, Iran offers “huge” financing opportunities: “The government is planning almost $40 billion of infrastructure development as sanctions ease up, some of which will require bank financing.” Iran, reckons Nima Obbohat of BlackRidge Associates, is similar to China in that “it has reached the same point where it needs to find a growth model for the economy, and solving the issues of the banking sector is key.” Boutique asset managers in London recently concluded partnerships with a trio of Iranian financial firms focused on the Tehran stock market, whose currently low P/E ratio could prove to be a major draw. With the announcement that Iranian banks had regained the ability to use the worldwide transaction system SWIFT, an Iranian central bank official declared that “banks from European countries including Germany, France, Britain, and Italy had been in talks to open branches” in Iran, a claim confirmed by sources to the Wall Street Journal.

Despite the enthusiasm exhibited by European companies in investing in Iran’s transportation and finance sectors, however, hydrocarbon extraction remains the bedrock of the Iranian economy. It is this sector which will require the most substantial investment if Iran is to take advantage of its hugely underexploited gas reserves and achieve the stated objective of upping oil production to levels last seen under the reign of the Shah (oil production reached 6 million b/d in the monarchy’s final years). Iranian crude costs almost two-thirds less to extract than the American variety and is the prime draw for international majors. The Western boycott of Iranian oil caused crude production in the country to decrease from 3.5 million barrels per day to just over 2.5 million b/d by the end of last year. Europe’s oil majors could prove vital to Iran, both in terms of investment and technology transfer, and in rebuilding the country’s rickety infrastructure.

With Saudi Arabia, the UAE and Iraq, all upping production to replace the Iranian crude taken off the market under the sanctions regime, Iran has no time to spare. Already the Islamic Republic has moved to develop new commercial terms designed to incentivize energy majors to maximise production by remunerating them through an agreed production share, with contracts lasting up to 20 years rather than the five typically stipulated under pre-sanctions contracts. President Rouhani’s European tour saw Total SA agree to import 200,000 b/d from Iran, with the French giant announcing that it is studying a number of exploration and development opportunities in Iran. It may soon be asked to reprise its role in the development of the largely untapped reserves of Iran’s massive South Pars gasfield. Meanwhile, Hellenic Petroleum, Greece’s biggest refiner, has committed to buying Iranian crude and Italy’s Saipem has agreed to build a 1,800 km pipeline and to upgrade refineries at Shiraz and Tabriz.

A source at Iran’s national oil company (NIOC) this month informed Reuters of Iran’s intent to seek payment in euros for its recently signed oil contracts with firms such as Total. The country will also seek to recover tens of billions of dollars it is owed by India and other purchasers of Iranian crude in euros. “With Iran now again linking to international lenders through SWIFT,” the source told Reuters, it was “easy for Iran to be paid in any currency it wants… And we want euros.”

While resuscitated commercial relations with Europe may fatten a considerable number of pockets both in the Iran and on the continent, losses stand to be made in some quarters. Brent crude slipped below $28 on news that NIOC had ordered a production increase of approximately 500,000 b/d just as sanctions were being lifted. The IMF forecasts that the dismantling of the European embargo will see Iran boost global oil production by 600,000 b/d in 2016. As pointed out in the Financial Times, this “would be equivalent to approximately half of global oil demand growth in 2016.” Moreover, Iran said in January that it would be selling its oil at discounted prices in a bid to attract European buyers. That this announcement followed on the heels similar announcement by Saudi Arabia’s Aramco sparked fears (or hopes) among some observers of a price war between the two Persian Gulf rivals.

Wells Fargo analysts estimate that the full-blown return to markets of cheap Iranian crude will rule out any sustained rebound in oil prices in the short term. In the long run, should Iran achieve its stated ambition of ramping up production to levels last seen under the Shah, and should counterproductive tensions between Iran and Saudi Arabia continue to prevent coordinated OPEC action, then the positive impacts on the global economy of an era of cheap petroleum could be offset by less welcome effects. Levels of investment in conventional oil production have seen a dramatic drop-off the world over: Woods Mackenzie, a commercial intelligence firm, calculates that projects accounting for a staggering 27bn barrels of reserves have been cancelled or postponed. Oil demand has been predicted by many to continue growing, meaning that this lack of investment bodes ill for an industry where, as pointed out by Paul Stevens, “the natural depletion of oil reserves requires producers to run to a standstill.” Iran thus poses a problem as well as an opportunity for the global oil industry, and Mr. Stevens speculates that the current oil environment could well lead to a decade of market instability and the threat of price shocks. Falling share values of oil majors could translate into pain for rich world pensioners, whose pensions depend on equities valuations, and thus into trouble in the wider economy. Developing country governments heavily dependent on oil for revenues could find themselves struggling to deal with internal dissent, adding to global instability.

The unambiguous loser from Iran’s budding reintegration into the global economy, however, appears to be Vladimir Putin’s Russia and its oil and gas industry. This is somewhat ironic given the prominent role Russia and Mr. Putin had been seen to play in striking the nuclear accord with Iran, as well as the fact that Russia and Iran have found themselves on the same side in a host of regional conflicts, most notably the Syrian war. In the long run, however, imports from Iran could go a long way to ending Russia’s relative dominance of European energy markets, some of which (such as Poland and the Baltic states) depend almost entirely on Russian natural gas. Ed Morse, head of commodities research at Citigroup, says that European oil companies eager to explore investment opportunities in Iran have found that the best short-term way to demonstrate this enthusiasm has been to buy increasingly large volumes of Iranian crude, “and the main victims of that will be Russia”. Donald Jensen, resident fellow at the Center for Transatlantic Relations, concurs. Russia, he writes, will lose out from the nuclear deal over the long term due to Iran now having better access to global energy markets and likely providing competition for Russian energy exports. “Even as it tries to keep good ties with Moscow, Iran will likely offset them by pursuing better ties with the West.”

The economic threat to Russia stems not just from the prospect of direct competition from Iranian crude. There now exists a very real possibility that a reintegrated Iran will provide the energy-rich states of Central Asia with a heretofore shut trade route for their own energy exports, westward toward Europe or south to the states of the Persian Gulf. Alex Vatanka of the Middle East Institute observes that, given Iran’s international isolation and the interminable conflict in Afghanistan, the only routes open to the Central Asian states up to now lay “to the north, [through] the giant Russia, and to the east [across] another giant China.” Now, he says, “You see from Astana to Ashgabat an interest in reconsidering what Iran can do for them geopolitically to lessen their reliance on countries like Russia and China.” Iran, says analyst Hussein Aryan, “offers the shortest non-Russian route for shipping Central Asian gas and oil to Europe”, noting that the Iran’s state oil company “publicly offered at the start of February to transfer Azerbaijani and Turkmen gas to Europe through Turkey.” Both President Rouhani and the vice president of Iran’s environmental protection agency have recently sought to emphasize the fact that Iran constitutes the shortest route for all these resource-rich countries to reach international markets.

As noted by Robert D. Kaplan in his book, The Revenge of Geography, Iran has already built “hydroelectric projects and roads and railroads in these Central Asian countries that will one day link all of them to Iran – either directly or through Afghanistan”, where Iranian commercial penetration has already grown to a significant extent. Iran, Kaplan writes, has already built pipelines connecting the country with Turkmenistan and Kazakhstan, and work is underway in constructing a rail link with the latter to provide it with “direct access to the Gulf.” Azerbaijan’s wide-ranging cooperation with Iran in the arenas of energy and water use, as well as already extensive transport links, have been seen to bring Azerbaijan political as well as economic benefits.

The five landlocked states of Central Asia with which the Islamic Republic has been busy constructing ever-expanding energy and transportation links are essential to US-backed European strategies for lessening the continent’s dependence on Russian energy. Azerbaijan is completing the construction of the major Trans-Anatolian Natural Gas Pipeline (TANAP) to export its gas to European markets via Georgia and Turkey. “TANAP will eventually have the capacity to ship some 60 billion cubic meters of gas per year and will ultimately need more than Azerbaijani gas to fill it”, leading some to speculate that Iranian gas could well join Azerbaijan’s in the pipeline. The EU’s Southern Gas Corridor and Trans-Caspian Pipeline (TCP) proposals both envision the importation of Azerbaijani and Turkmen gas, while the former could feasibly facilitate the intake of additional supplies from Kazakhstan and Uzbekistan. Although the TCP is projected to circumvent Iran as well as Russia, commentators and officials have pointed out that building a ground pipeline through Iran would be much easier and less costly than it would be to build the pipeline beneath the relatively corrosive and disputed waters of the Caspian Sea.

Mr. Putin will surely be watching such developments closely. Despite a tentative easing of pressures and the prospect of a successful $3bn bond issue, low oil prices and Western financial sanctions have seen the value of the rouble halve since 2014 and placed an economy already plagued with structural problems in yet direr straits. Like Iran, oil and gas sales accounted for nearly 68% of Russia’s total export revenues in 2013, and possibility of Iranian and Central Asian exports challenging Russia’s long-held position as Europe’s predominant supplier of hydrocarbons will have caused grave concern in the Kremlin.

Potential winners from the Iran deal go beyond Europe and the Central Asian states. The IMF has predicted that the United Arab Emirates will see an entire percentage point added to GDP growth in 2016 thanks to the lifting of sanctions on Iran. Just one week after the provisions of the nuclear deal came into effect, China, the top buyer of Iranian oil, concluded an agreement with the Islamic Republic to increase trade between the two nations – both founding members of the Asian Infrastructure Investment Bank – to $600bn over 10 years. Dreams abound of reviving the old Silk Road.

Needless to say, significant obstacles remain before the prospective winners from Iranian reintegration, including the Islamic Republic itself, can reap the benefits. Hopes of increased prosperity through renewed international engagement are contingent upon a number of factors that lay beyond Iranians’ control. First, and most obviously, Iran’s terms of trade will remain relatively disadvantageous so long as the environment created by the oil glut of recent years persists. Second, the value of international trade fell 13.8% last year – its first contraction since the aftermath of the global financial crisis in 2009. Iran’s reintegration has not come at an especially fortuitous time: as pointed out by Nouriel Roubini, the world economy currently finds itself confronted by “at least seven sources of global tail risk,” ranging from worries about a hard landing in China and the serious trouble brewing in emerging markets to the lower returns challenging major, especially European, banks and the possibility that the Fed acted too early in raising interest rates in December. The “global economy,” writes Roubini, “is moving from an anaemic expansion… to a slowdown”, while years of low interest rates in rich countries means that central banks in many of the countries Iran will look to for increased trade will have less room for manoeuvre in the event of another recession.

Other factors, independent from but not entirely unrelated to the state of the global economy, may complicate the process of Iranian reintegration. Although it makes sense to seek payment for oil in euros in light of Iran’s expanding trade with Europe, and relying less on the dollar would provide a measure of protection should the US decide to re-impose sanctions in the future, moving to euros could prove to be a blunder: many firms predict that the euro will continue to decline in value against the dollar, especially if the Fed proceeds with another rate rise. Moreover, analysts conservatively estimate the time it would take before any Central Asian energy export projects through Iran became operational at five years. Many put it closer to a decade. And although there have been murmurs of European interest in testing the waters of the Iranian financial sector, Iran’s banks – which will be crucial to deal-making and cash flow as the country reengages with the world economy – are generally undercapitalised and overburdened by politically allocated nonperforming loans.

Although the removal of sanctions undoubtedly stands to propel Iran into a new era, the country remains under the control of a heavy-handed and repressive clerical regime. Political stability is far from guaranteed, despite the relatively high level of institutionalization that characterizes Iranian politics and notwithstanding a seeming consensus regarding the necessity of reform and international engagement (only reinforced by the results of last week’s parliamentary elections). In addition to a struggling middle class, another major beneficiary of sanctions relief is likely to be the Iranian Revolutionary Guards Corps (IRGC), the organization responsible for the protection and security of the regime. Estimated by one Western diplomat to control business activities with an annual turnover of $10-12bn, the feared Guards are involved in industries ranging from energy to construction and, as one Iranian official recently told Reuters, “More money means more funds for the IRGC.”

The featured image is Public Domain.