Iran's Energy Sector at the Crossroads

Transition through Gas

Chris Cook

London 15th June 2015

Iran's Energy Sector at the Crossroads

Introduction – Cook's Tour

Looking Back – an oil market review

To the right, the Dollar & to the left, the Euro?

Looking Forward – a Transition though Gas?

Cook's Tour – Personal View

Fraud Investigation to Market Regulation to Market Development

1990/1996 Director, International Petroleum Exchange

1998/2001 “OilClear” - a market-based Dot Com

2000 - Blew whistle on 'micro' oil market manipulation

Cook's Tour – Personal View

June 2001 – contacted Iran Central Bank

May 2004 – Iran Oil Bourse project begins

Since 2004, a Long & Winding Road....and eight visits to one of the finest countries in the world

Some impressions along the way....

Cook's Tour of the Oil Market

1945 Bitter Lake - Saudi/US Energy Security

Energy Security: 1973 Oil Shock – price up 400%

US and Energy Security - 1973

US secretly agreed 400% oil price increase from $3 to $12/bbl with Shah of Iran & hence OPEC

Outcomes:

1/ Petrodollar – US agreed with Saudi Arabia to deposit dollar proceeds in US $ assets

2/ US got oil for T-Bills.....OPEC got blamed for high prices

3/ Alaska, North Sea, US Gulf oil viable & funded at $12bbl

4/ US/UK energy security achieved via stealth carbon tax

The Age of the Middleman

Enter the Exchanges

Volatility led to risk and formation of oil exchanges

First - New York Mercantile Exchange (NYMEX)

Then International Petroleum Exchange (IPE)

NYMEX introduced West Texas Intermediate (WTI) oil contract & IPE introduced Brent (North Sea)

US WTI Crude Oil Price History

Brent Crude Oil Price History

Enter the 'Wall Street Refiners'

In the 1990s investment banks began to take a role as financial intermediaries - “Wall Street Refiners”

They began to create new funds for risk averse 'inflation' hedgers to invest in commodity markets

Passive Investment

Exchange Traded Funds and Index Funds

Quasi-ownership not debt

Passive investors whose aim is to avoid loss rather than make profit – 'inflation hedgers'

Middlemen do not take market risk but keep credit risk & profit from trading on asymmetric information eg HFT

Passive Investment & Inflation Hedging

Speculation - putting capital at risk for transaction profit – active two way (long or short)

Producer Hedging – off-loading commodity risk in exchange for dollar risk – short only

Inflation Hedging - off-loading dollar risk for commodity risk – return OF not return ON capital – long only

Financialisation of Oil

Goldman Sachs Commodity Index fund created 1992

& marketed as 'inflation hedging'

BP & Goldman Sachs joined at the head from 1995

BP effectively controlled Brent benchmark from 2001 when Forties field was added to Brent field

Financialisation of Oil

BP (IOC) locks in oil price through forward Brent sales but refiners tend not to buy forward > 3 months

GSCI 'long-only' medium & long term buyer of Brent

GSCI fund buys & rolls over Brent futures contracts while BP sells & rolls over Brent futures contracts

Financialisation of Oil – Prepay

Introduced by Enron c1999 as ('off-balance sheet') funding invisible to investors & creditors

GSCI lent dollars interest free to BP via J Aron (Goldman Sachs trading arm)

BP lent oil to GSCI via sale & repurchase with J Aron

Financialisation & the Death of Markets

QE and 0% $ interest rates – 'buy anything but dollars'

Correlated bubbles caused by 'inflation hedgers'

Commodity prices lose touch with production, consumption & inventories

Equity prices lose touch with underlying flows of dividends and retained profits

Correlated Commodity Bubbles

Market Cardiac Arrest due to Financialisation

World Oil Markets Move Together

Macro (medium/long term) Market Manipulation

If producers can support prices they will eg tin, copper

Such 'Macro' manipulation can persist for many years

Enron-style 'Prepay' contracts eg Chesapeake Energy

Producers lend oil to passive investors

Passive Investors lend dollars to producers

Macro (medium/long term) Market Manipulation

Investment Banks intermediate producers & investors

Two tier (false) physical market Dark Inventory of oil in custody with economic value prepaid by investors Asymmetric information re inventory is profitable for privileged banks and traders

Oil Market Bubble 1.0

Bubble 1.0

North Sea Benchmark – Brent Complex

Collapse

Collapse

2008 – Peak Credit

Collapse of Lehman Brothers

Collapse of interbank trust – trade credit freezes

QE & 0% interest (ZIRP) to prevent debt deflation

Systemic solvency problem (unsustainable debt)

Credit intermediary banks systemically short of capital

Collapse – July to December 2008

Oil trade credit dries up so oil trade dries up

Oil price collapses from manipulated $147/bbl spike

Saudis cut 1.5m bpd and then in Dec 2008 OPEC announces 2m bpd cut

Makes no difference

Jan 2009 Obama ('Big Money' President) takes office

Market Price Structure

Backwardation

- current (spot) price higher than future price

- no limit to backwardation

- typical of under-supplied market

Contango

- current (spot) price lower than future price

- if contango exceeds cost of storage etc then traders buy now, sell forward & make risk-free 'arbitrage' profit

- typical of over-supplied market

2009 Supercontango

2009 Supercontango – Inflating Bubble 2.0

Supercontango

2009 Supercontango

Supercontango indicative of market oversupply, but rapidly rising price simultaneously indicated market undersupply

Question. Why did prices rise dramatically in an oversupplied market?

Answer. Financial buying was opaquely supporting the oil market price by funding oil inventory

High Prices – Cui Bono?

Producers If a commodity producer can support prices then he will Brent Complex in terminal decline makes support easy

Market support requires Capital: Sovereign reserves or Risk averse ('passive') investment funds

And liquidity Central Bank Quantitative Easing (QE)

Follow the Money: 2009 Saudi Intervention

North Sea Benchmark – Declining Production

Follow the Money – Oil Price & QE

Follow the Money – Oil Price & QE

I forecast $45 to $55oil post QE

But end of QE took a long time!

2015 Oil Price Rebound

Brent & WTI prices hit lows of c$45/barrel by mid January

Within six weeks Brent rose 32% while US WTI rose 8%

Not physical demand by refiners: due to financial demand

Question. Where did liquidity come from? 22nd January European Central Bank announced € QE Oil price and German Bund yields now 92% correlated

Question. Where did investment capital come from?

Answer. Follow the Money

Follow the Money – 2015 Saudi Intervention

US Oil Production

US Energy Security - Outcomes

History does not repeat itself, but it does rhyme High cost shale crude oil was viable/bankable because

oil prices were supported for 5 years above $80/barrel Demand for oil products also fell due to efficiency Renewable energy substituted for carbon fuels

Stone Age did not end because of a shortage of stones US oil swing producer & security of supply. At a price Oil market price effectively capped at $60 to $70/barrel

Bitter Lake to Bitter End?

US energy security through shale oil is the most significant market event since 1945

Saudis appear to have been ejected from the US tent

US is now pivoting to the last remaining significant reserves of undeveloped low cost oil in Iran & Iraq

End of the Petrodollar?

There are signs that Saudis may have begun switching reserves to € assets & access to free € QE liquidity

Petro Euro has long been an ambition of the EU & ECB

Have Saudis switched from Petrodollar to Petro Euro?

Is Oil Market Capped at $60 to $70 per barrel?

IOC 'Oil as a Commodity' transaction model squeezed Irresistible Force of rising E & P costs squeezes NOCs

against Immovable Object of $60/$70 bbl oil price cap

IOC Options Consolidate – defers the inevitable Switch to natural gas eg Shell Compete for last remaining low cost oil in Iran/Iraq

Or - transform to Capital Lite 'Energy as a Service' model

1973 Oil Shock – Price up 400%

Energy Security - Danish Approach

Mandatory overarching operating principle for energy policy

Least carbon fuel cost - for a given output of heat, electricity or power, minimise carbon fuel input

Danes funded investment via high local taxation

Outcomes

Danish GDP has doubled, while energy use has been flat & carbon fuel use has declined

Decentralised production & consumption; local heat networks & renewables – a Natural Grid

NOC Strategic Aims

NOCs aim for:

- stable transparent high prices

- security of demand

- resource sovereignty (ie ownership)

Other Participant Strategic Aims

Consumer

- stable transparent low pricing

- security of supply

IOC (Middleman)

- security of supply & demand

- stability & transparency....up to a point.....

- Booking (ownership) of reserves to satisfy shareholders

Trader (Middleman) - stability & transparency are Death

Bank (Middleman) – asset ownership by borrowers

Problems - Iran and Energy as a Commodity

Existing legacy infrastructure fragmented, fragile & often inefficient (often <20% output efficiency)

Huge carbon fuel waste between well & consumer

Iran competes within OPEC for sales of energy-as-a-commodity

More Problems

Intractable conflict between Iran resource sovereignty & IOC need for reserves on balance sheet

Adversarial relationships with traders & banks

Iran & Consumers both lose from opacity & volatility

Volatility & bank capital shortage makes conventional bank financing & funding increasingly difficult

Energy as a Service

Least Carbon Fuel Cost Principle - minimise carbon fuel system input for given electricity, heat or power output

Market Structure & Instruments Energy Swaps – production sharing supply

agreements – Capital Partnership Energy Credits – risk sharing of energy prepay credit

instruments – Guarantee Society

Energy Swaps

Iran supplies flow of oil or natural gas

Iran agrees proportional shares of product or service output with service providers & consumers

Balance of output is available to investors

Investment may be conventional (eg $/€ bank loans) or unconventional (energy loans of prepay energy credits)

Oil for Product Swap

RefineryRefinery

Investors

Consumers

Service Providers

%Prepay

Oil

NIOC

Products

Gas for Power Swap

Generator (eg CCGT)

Generator (eg CCGT)

Investors

Consumers

Service Providers

%Prepay

Gas

NIGC

Power asService

Prepay Energy Credit

What it is

- promise issued in exchange for value received

- returnable in payment for supply

What it is not

- Debt - no right to demand money

- Derivative – no right to demand delivery

- Equity – no ownership right in respect of sovereign asset

Requires trust between Promissor & Acceptor/Investor

Prepay Energy Credit funding – Energy Loans

Energy Loan – Value Proposition

- consumers may pay in advance & lock in price

- Iran obtains interest free credit & locks in price

- investors obtain return in intrinsic value of energy

- investors may use for consumption or sell to consumers

Requirements

- physical energy market & pricing benchmark

- accounting system

- framework of trust – Guarantee Society agreement

Energy-as-Service – Value Propositions

Iran & Consumers - share cost of supply infrastructure

Service Providers - receive agreed %age of revenues - balance of revenues available to investors

Investors - buy prepay credits & so make energy loans

Consumers – pay for energy delivered using either conventional payment or energy prepay credits

Example - Caspian Energy Grid – KAT Core

Turkmen Gas/ Power Hub

Tried & Tested - Marchwood (UK - 58% efficient CCGT)

Tried & Tested - BritNed and NorNed HVDC Links

BritNed 260km - 600MW NorNed 580km - 600MW

KAT Core - Outcomes

Turkmen NOC exports power to Caspian littoral states

Energy savings fund development of infrastructureTurkmen NOC conserves gas which is then available

for generation or exportAzeri & Kazakh NOCs release production for export

through reduced local carbon fuel requirement Caspian energy market & pricing benchmarkMinimise funding costs: energy loans bear no

compound interestIncrease resilience – Caspian Energy Grid also

capable of carrying regional renewable energy power & load balancing

Energy Security - Transition through Gas

Security of demand for Iran

Supply of oil & gas as a service

Collaboration, stability & transparency adopted as market standard Win/Win behaviour

Shared services, costs & risks via market framework agreement

Energy Security - Transition through Gas

Optimal low carbon financing & funding via Energy Loan direct investment in carbon fuel savings

Payment of subsidies through Energy Dividend of energy credits

Least carbon fuel cost principle minimises CO2 emissions: higher the carbon fuel price, the more $ profit in saving it

Instead of oil priced in $ (or €) and gas indexed against oil, dollars, euros & oil are priced in energy value of gas

Beyond OPEC

OPEC has been dead and on life support for years as a puppet of the Saudis

Global oil market pricing through Brent Complex is completely corrupt with no replacement in sight

Dollar and euro banking systems essentially bankrupt

New multilateral global oil & gas institutions are needed to bring together producers & consumers directly

Non-OPEC NOCs are well placed to share costs of creation of a new oil & gas market platform