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    Middle East
     Dec 23, '13

Iran's oil: Pay it forward
By Chris Cook

"It is an old maxim of mine that when you have excluded the impossible, whatever remains, however improbable, must be the truth."

The global markets in crude oil and oil products are not the most obvious subject for Sherlock Holmes' famous maxim but we live in strange days.

The power of the international oil companies (IOCs) - such as

Exxon, Shell and BP - has been in secular decline for decades as producer nations have come to assert themselves through their own national oil companies (NOCs).

In a parallel trend, we have also seen the IOCs selling assets where their returns are solid, but slim - such as mature producing oil fields (upstream) and oil refineries and distribution assets (downstream) - in favor of exploration and development of new oil and gas fields which yield higher returns.

The problem for the IOCs, as the global head of exploration of one of them explained to me in Baku in June, is that their margins are being squeezed between the fiscal and commercial demands of governments and their NOCs on the one hand, and soaring contractor costs in increasingly difficult fields, on the other hand.

IOCs see governments increasingly unwilling to cede ownership of sovereign assets, and are unwilling or unable - since the breakdown of the financial system in October 2008 - to borrow to develop assets over which they have no ownership. NOCs that wish to raise development finance for their part, have also found themselves hamstrung by the lack of availability of bank finance.

So if the traditional answers to the question of finance capital - equity and debt - are impossible, what is the improbable solution which remains? And why is it so important to Russia and Iran?

Pay it forward - prepay
There's nothing new about prepay: it is the form of finance capital which pre-dates all others.

A producer who sells production forward at a discount is entering into a prepay transaction, and the rate of return for the investor is literally the rate at which the investor can return the producer's prepay credit instruments in payment for supply. Note here that unlike in a forward or futures contract, the investors have no right to demand delivery: just the right to use the prepay instrument to pay for supply.

In fact, for 600 years UK sovereigns funded themselves through prepayment of taxation at a discount by taxpayers, and the wooden credit instrument that was returned (hence the phrase "Tax Return") to the sovereign's exchequer for matching and cancellation against its counterpart was known as the "Stock".

It was the smartest kid on the block - Enron - that in the late 1990s reintroduced prepay. Through opaque three-way deals involving investment banks JP Morgan Chase and Citibank, Enron entered into off-balance sheet prepay funding arrangements that were not visible either to their investors or creditors and thereby misled them as to the true state of Enron's finances.

Just as insidious, but on a far greater scale, the first decade of the 21st century saw BP enter into prepay oil contracts funded by commodity index investors via Goldman Sachs. This enabled BP to borrow dollars interest free while lending oil to the investors via prepay contracts and related derivatives. The marketing geniuses at Goldman Sachs sold this form of investment, which gave no return on investment, but which gave exposure to the oil price, as an inflation hedge, and risk-averse investors lapped it up.

After the oil market price collapsed from US$147/barrel in July 2008 to $35/barrel in December 2008, the Saudis turned in desperation to prepay contracts, facilitated by their long-term investment banker J P Morgan. These prepay transactions - essentially oil loans - were easily funded by billions of dollars of investment seeking inflation proofing at a time when interest rates were at zero and the Federal Reserve Bank had begun printing what became trillions of dollars.

Russia and prepay
There are now several examples of prepay funding that are transparent to the public. Far and away the most significant is that by Rosneft, which is now the pre-eminent Russian oil producer.

When Rosneft bought out the BP/TNK joint venture earlier this year, the cash requirement to pay BP (which received $16.7 billion plus a 12.5% stake in Rosneft) and the four TNK oligarchs (who received $27.7 billion) was well over $40 billion. Rosneft took out short-term bridge financing to pay for this acquisition and has since been urgently seeking long-term funding at a time when bank loans are scarce and expensive.

The only option open to Rosneft other than issuing more shares (which defeats the object of taking back State ownership) is to enter into prepay agreements, and this is precisely what they have been doing since the acquisition.

Firstly, Rosneft has entered into several relatively short-term prepay deals with traders such as Trafigura and Glencore; secondly it has been entering into crude oil and product supply agreements with BP, which include a $5 billion element of crude oil prepayment, and finally, on October 22 it announced a Memorandum of Understanding with the Chinese state buyer Sinopec in respect of a massive 10 year & 100 million tonne deal involving prepayment.

However, such long term deals are always fragile, since they are priced in dollars and any significant change in the economic relationship between Russia and China will inevitably disadvantage one side or the other to the extent that they will almost certainly eventually repudiate the agreement.

This structural dollar benchmark pricing problem will remain for as long as the dollar is the global standard currency for trade and exchange.

Iran and prepay
In my view, based upon my high level (and recent) dealings with Iran commencing many years ago, the Rouhani administration is completely set upon Iran's re-entry to the global community in order that the country may access the global technical and financial resources necessary to fulfill its potential as a leading nation.

In the oil and gas sector, Bijan Zanganeh, the extremely astute energy strategist who is Iran's petroleum minister, has announced that Iran is to introduce a new contractual regime aimed at attracting the IOCs back to Iran. Conferences are planned in Tehran and London this spring at which new arrangements will be outlined. The current position is that Iran has historically insisted upon "buyback" contracts, which very few, if any, IOCs will accept, while the production-sharing contracts that the IOCs are able to foist on weaker nations are unacceptable to Iran.

My proposal to HE Zanganeh, which his key advisers are studying, is to combine production-sharing capital partnership agreements with generic prepay contracts in a simple but radical way. This is - interestingly - entirely consistent with genuinely Islamic finance, as opposed to the institutionalized hypocrisy that tends to pass for it. This is because using prepay there is a return in the value of energy, rather than in money issued by banks and based upon interest-bearing debt.

Prepay and an energy dividend
We have seen above how prepay contracts enable governments and multinational corporations to access funding from other governments and multinationals. The average man on the street does not have a use for crude oil or for large shipments of products and cannot therefore participate in these wholesale markets.

However, prepay instruments on a retail scale in different forms of energy, such as natural gas, electricity and fuels such as gasoline, heating oil and diesel, open up interesting energy policy options because they are relevant to the man on the Tehran street.

So for instance, my advice to Iran's new administration is to increase domestic energy prices to the global level, which they are already attempting to do in order to reduce crippling subsidies. Instead of paying subsidies in inflationary rials issued by Iran's Central Bank Markazi, I propose that they should issue energy prepay credits returnable in payment for energy use, with the different forms of energy use being priced by reference to a standard energy unit of account.

The outcome would be an Energy Dividend - not unlike that paid to Alaskans - but paid using an intrinsically valuable instrument that encourages Iranians to reduce existing massively profligate and environmentally destructive carbon fuel use. A similar technique would work equally well in other energy-producing nations such as Venezuela and Nigeria, with dysfunctional economic systems afflicted by the oil curse of dollar economics.

Such a policy may be straightforwardly achieved using existing mobile payment technology and Iran's Shetab banking system to bypass the Western-style private banking monopoly on payments. Iran may connect the central bank (or an Energy Treasury, as I advocate) directly with the Iranian public in respect of payments, while credit and loan administration and risk management remain with the private banks as service providers.

The use of mobile payments, which can offer privacy but not the anonymity of conventional paper currency, will act to minimize the destructive corruption of most resource rich nations. In that context, it is ironic to note that the very financial sanctions intended by the US to bring about Iranian regime change (and which did indeed probably bring them to the negotiating table) has actually benefited the Iranian public by acting to enforce honesty through denying access to Swiss bank accounts in hard currencies. The Law of Unintended Consequences in action, again.

The last big thing
Most people think that the financial system has always been this way, but a moment's thought tells us that something must have been working before modern bank-centric finance capital first made its appearance 300 years ago. Contrary to a pervasive myth, that something was not barter, which occurs only where the trust necessary for credit is absent, but rather prepay - Pay it Forward - which has existed for thousands of years.

The prepay instrument is essentially a form of undated or open capital that is capable of replacing the conventional, complex and conflicted equity, debt and derivatives instruments which grew like financial weeds in the past 300 years and eventually led to unsustainable concentration of wealth in very few hands.

The pervasive direct instant connections of the Internet, combined with simple collaborative agreements and protocols, enable direct peer-to-peer credit (which is not the same thing as peer-to-peer loans of existing money) and direct peer-to-asset investment through prepay instruments in the future productive value of productive assets.

The final enabler of the decentralized economy now rapidly evolving is the recent emergence of the Bitcoin phenomenon using a "blockchain" code to verify secure value transfer. As a currency, however, Bitcoin and its many clones suffer from the problem that - like emissions credits - the value upon which they are based is the proof of past energy expenditure by the creator.

This proof of work by someone else for their own account carries no intrinsic value to the recipient. It follows that the value of Bitcoins is purely subjective, and the price is volatile, being exposed to the madness of crowds.

But if such electronic coin/blockchain creation were to be credibly linked to the provision of future energy supplies, then there is no reason why a new global currency - EnergyCoin, PowerCoin or GasCoin - could not emerge in use, particularly in mobile payment systems in the developing world.

Finally, we now see Iran excluded from the global financial system, and in my view the entrenched US legislature will never relent, being driven by misguided ideology rather than reality. Since the bank-centric euro is terminally broken, conventional trade payments will remain impossible for Iran, and energy prepay, no matter how apparently improbable, therefore offers a solution that Sherlock Holmes would approve.

Chris Cook is a former director of the International Petroleum Exchange. He is now a strategic market consultant, entrepreneur and commentator.

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