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Energy & Climate

The India-Iran Oil Payment Crisis

The financial sanctions imposed against Iran over its nuclear program have severely disrupted Iran’s petroleum trade with its second-largest customer, India. In this note we assess the impact on global oil markets and India-Iran relations.

The financial sanctions imposed against Iran over its nuclear program have severely disrupted Iran’s petroleum trade with its second-largest customer, India.  After a warning eight months ago by the Reserve Bank of India, the country’s central bank, most Indian banks stopped handling transactions for Iran. This immediately froze Indian payments for Iranian crude, largely done in dollars, as the rupee is not a convertible currency. By the end of July, Indian refineries owed Iran $5 billion in arrears, and Tehran was threatening to withhold August’s crude shipments.

New Delhi has been trying to overcome this problem by experimenting with a number of institutionalized payment methods, including countertrade, the use of third country banks and payments in other currencies. These have proved largely unsuccessful. India and Iran are presently using a bank in Turkey to funnel payments, but this is at best a temporary solution.

The longer it takes for a risk-free payment method to be found, the more likely it is that Indo-Iranian petroleum trade will be reduced to a trickle. Almost all of the Indian refineries that use Iranian crude have, as of late July, begun looking for alternative sources. If these temporary fixes do not become permanent, Iran will be in serious danger of losing India as a customer.

If that happens, Tehran will likely redirect its Indian crude shipments to China, freeing up equal amounts of Saudi crude for consumption in Indian refiners.  So the net impact on global oil markets would be minimal. But the revenue implications for Tehran could be significant. Chinese oil majors are tougher negotiators than the small Indian refineries currently buying Iranian crude. Increasing China’s share of Iranian crude exports coupled with the hassle-factor imposed by US sanctions would put Beijing in a strong price negotiating position.

The Indian government continues to look for ways to maintain Iranian crude supply in support of broader geopolitical goals. Since the largest customers for Iranian crude are state-owned refineries, New Delhi can ensure demand – but only if it can find a solution to the payments impasse. That will prove increasingly difficult if current US sanctions persist.

An Evolving India-Iran Energy Relationship

The rising threat of sanctions over the past five years has already significantly reduced the scope of Indo-Iranian energy trade. Originally, the relationship had three elements.

One, and what was once the economic core of the energy relationship, was a petroleum trade whereby Iranian heavy crude was sent to India for refining and re-exported to either third countries or Iran itself. This trade was overwhelmingly concentrated in the largest private Indian energy concern, the Reliance Corporation.

Two, there was a much smaller direct import of crude oil that was refined and sold largely within India by four smaller refining companies. Four of these are state-owned – Mangalore Refining and Petrochemicals, Bharat Petroleum, Hindustan Petroleum and Indian Oil Corporation — and one is private – Essar Oil.

Three, there was a heavily negotiated but never implemented plan for Iranian natural gas supplies. Because Tehran lacks gas liquefaction capability, the proposed transport mechanism was a pipeline running from Iran through Pakistan and on to India. This pipeline has been bandied around since 1995, but sanctions and, more importantly, Indo-Pakistan bilateral hostility has kept it in the realm of theory. India currently receives no gas from Iran.

The expectation of tightening sanctions and the possibility of military action against Iranian nuclear facilities led the Reliance Corporation, India’s largest private sector petrochemical firm, to slowly unwind its exposure to Iranian crude supplies.

It helped that from 2006 Saudi Arabia made a determined push to build a strategic energy relationship with India, with one of its goals being to shoulder Iran out of the Indian oil market. Reliance, in particular, was targeted because its refining capacity was a good match for Saudi crude. By 2009 Reliance had stopped exporting products refined from Iranian crude to third countries and by spring 2010 it had ceased exporting refined products to Iran itself. As a result, Saudi Arabia last year became the largest supplier of crude to India, both for domestic consumption and Indian petroleum product exports.

Following the imposition of US financial sanctions last year and the subsequent central bank warning, the squeeze fell on the smaller Indian refining firms left purchasing Iranian oil who were suddenly unable to pay for crude shipments. In July of this year, Iran indicated it would withhold shipments unless the payment issue was resolved. The affected refineries began buying on the spot market and two of them are known to have approached Saudi Arabia for an additional one million barrels for the month of August.

Finding an alternative has been most problematic for Mangalore Refining, Iran’s largest Indian client, which consumed 150,000 of the roughly 400,000 barrels of oil that India imports daily from Iran. This firm alone owes Iran nearly $ 3 billion for unpaid crude shipments.

India Tries to Adapt

New Delhi seems to have been surprised by its own central bank’s warning to Indian financial institutions not to carry out transactions with Iran following the imposition of US financial sanctions. Having done little in the way of preparation, the Indian government has spent 2011 scrambling to find a means to pay Tehran. With a nonconvertible currency and few exports to Iran, India immediately began running up unpaid bills.

Until May 2011 India was able to transfer funds through the German-registered Iranian bank EIH. When this bank was shut down by Berlin, Iran proposed that the two countries trade in renminbi (RMB). This was turned down by India’s foreign ministry which was wary of allowing the RMB to underpin an important and strategic trade relationship. It also explored using the financial sector of a developing third country, among them Oman, without success.

India tried to expand exports to Iran to make barter or rupee trade possible, pointing out there was scope for Iran to import auto components and various engineering products (India exports less to Iran than most other Iranian oil consumers – Figure 1). However, Tehran stonewalled on these proposals, arousing suspicions that Iran was deliberately trying to force India to violate the sanctions and cause friction between India and the US.

This, along with a desire to defend against Saudi encroachment, is likely why Iran has allowed India to run up such a large number of unpaid bills. Nonetheless, in the third week of July, Iran began to signal impatience. Indian suppliers did not receive the normal notifications for Iran’s August shipments.

Faced with imminent supply disruptions, last week New Delhi found a temporary solution – processing payments through Halkbank in Turkey. Mangalore Refining, for example, is now paying off some arrears through Halkbank with the state-owned Union Bank of India acting as the Indian intermediary. Iran subsequently announced that it would continue to supply crude, even while holding talks with India on how to find a long-term solution.

Better still, say Indian officials, would be the use of an Indian bank with little or no international exposure as the primary conduit. The Union Bank of India and Dena Bank, both loss-making and state-owned, are the leading candidates for this role. New Delhi’s hope is to use several different routes for payments – countertrade, a few Indian banks, and third countries like Turkey – to get around sanctions. This is likely sufficient to pay down arrears, but is not enough to ease refiners’ supply security concerns going forward. By September, if Iran and India have not found a more reliable solution, many refineries will start diversifying away from Iranian supply.

Oil Market Implications

Even if all Indian refiners stop buying from Iran, the impact on the oil market overall would be quite modest. China, Japan and Korea could all absorb an additional 400,000-500,000 bpd of Iranian oil in refineries currently processing other Middle Eastern medium sour crudes (Figure 2). That oil would then be freed up for Indian refineries, keeping the market in balance. 

This would not, however, be good news for Tehran, as reducing the number of Iranian oil customers increases their bargaining power. Indian refineries have been largely unsuccessful in winning price discounts from Iran to make up for the hassle of dealing with the US sanctions regime. Chinese oil majors would be considerable tougher negotiators if asked to take on India’s current Iranian oil imports.

New Delhi’s Interest in Defending Iranian Trade

While Tehran doesn’t want to lose India as a customer, New Delhi isn’t particularly eager to lose Iran as a supplier. Despite the availability of a Saudi alternative, Indian officials say they will continue to plug away at finding a way to maintain a petroleum bridge with Iran for the following reasons:

First, India prefers to have a diversified petroleum basket. New Delhi differs with Washington when it comes to views on Iran versus Saudi Arabia. “Iran is difficult, but Saudi Arabia is not our idea of a nice country,” said an Indian diplomat, referring to long-standing Saudi support for Pakistan and its export of ultraconservative Islamic ideology.

Second, India sees Iran as part of a hedging strategy against the fallout of a possible full US withdrawal from Afghanistan. New Delhi believes such a withdrawal would probably result in a Pakistan-backed Taliban regime in Kabul. India would then seek to revive the Northern Alliance – a group of anti-Taliban Afghan militia previously backed along with Iran and Russia. Tehran has already been pushing hard for the three countries to resuscitate this old understanding.

Third, the US has declined to impose similar sanctions on Pakistani entities trading with Iran, including buying petroleum, which has rankled some Indian officials.

Fourth, strategically India sees Iran more as a future source of natural gas than a present source of oil. There is a widespread belief in India that the US’s present posture of hostility towards Iran will not be sustained beyond a few more years, and India does not want to find itself out in the cold if international political tensions ease.