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November 16, 2004

Iran & its Nuclear Quest

Let me say straight out that I don't trust the Mullahs of Iran having control of the nuclear fuel cycle. This weekend's report on Iran agreeing to freeze their fuel cycle development have many hailing Iran for agreeing to halt its uranium enrichment. The New York Times was more balanced in noting the temporary nature of the suspension. After witnessing this whole process play out once again, I'm left even more convinced that both the US and European approaches to the problem are destined for failure and the common thread that binds both approaches is that they seek to stop Iranian domestic nuclear fuel enrichment and are only using Security Council sanctions as a stick. I can't see this process working. The sanctions against Iraq were easily subverted and Iran's economy is much larger, and the temptation to break the sanctions would be too great for them to be as effective as we'd like. Short of invasion by the US, Iran will achieve its goal of nuclear power generation, and if under sanction, it will develop the fuel cycle for it is driven by internal structural failures and political pressures that are pushing it inexorably in that direction. Our strategy should be more narrowly targeted on derailing the Mullah's ambitions of piggybacking their nuclear weapons ambitions on the inevitable development of the fuel cycle and offering some carrots to enable the Iranians to abandon the domestic fuel instrastructure and it is only by focusing on these aspects that we can safeguard our own interests.

Let me touch on a few points that I think warrant elaboration before I return to the structural failures and what I see as the way forward.

Why does Iran, which is the world's sixth largest oil producer need nuclear power? If we restrict our analysis simply to this point we could ask the same of the world's second largest oil producing country, the United States. Here is the CIA's estimate of Iranian production.

A more nuanced analysis of Iran's drive for nuclear power needs to also account for domestic oil consumption, which the CIA lists as 33% of oil production.

Delving a little deeper we need to look to the future to understand what Iran is about to face and here the writing is on the wall. Iran is being hammered by an exploding population. Consider the situation as reported by Anthony Cordesman in his report Demographics and the Coming Youth Explosion in the Gulf This report is well worth the time to read and covers a diverse range of topics but I'll only pull a few points to support my thesis. In 1996, 45% of Iran's population was under 14 years old and the fertility rate was 4.72 children per woman.

As this graph illustrates, Pop-GDP growth.jpg
the population is soaring while GDP/capita is falling drastically and this graph
Pop Growth.jpg
shows how quickly the Iranian population is growing.

The economy is overly reliant on the oil sector and is stifled by statist controls. It has amassed a foreign exchange surplus of late due to the higher price of oil, but huge structural problems remain, primarily inflation and high unemployment rates. The US Dept. of Energy country profile of Iran states:

Despite relatively high oil export revenues, Iran continues to face budgetary pressures, a rapidly growing, young population with limited job prospects and high levels of unemployment; heavy dependence on oil revenues; significant (but declining) external debt; high levels of poverty; expensive state subsidies (billions of dollars per year) on many basic goods; a large, inefficient public sector and state monopolies (bonyads, which control at least a quarter of the economy and constitutionally are answerable only to supreme leader Ayatollah Ali Khamenei); international isolation and sanctions.

Oil's significance to the Iranian economy makes the dependence perilous in terms of economic concentration and lack of buffer during periods of low oil prices . Iran's (89%) dependence on oil exports is only exceeded by Libya (97.26%) and Kuwait (92.4%.) A bright spot is that Iran's oil exports to Europe account for 80% of its total exports bound for Europe meaning of course, that the Europeans are importing goods from Iran that much of the world sources elsewhere.

The exploding population is leading to increased demand for electric power of about 7%-8% annually:

Iran is building significant new generation capacity -- both thermal and hydroelectric -- with the goal of adding 30 GW over the next ten years (Iran estimates that it may need 90 GW of power generating capacity by 2020).

This year alone Iran's electricity consumption has increased by 3,000 MW.

The Iranian leadership isn't blind to what the future portends and some of their other, non-nuclear, initiatives lend support to the benign part of the nuclear dilemma - the need for domestic production of electricity. They've invested over $1.5 Billion in the electricity sector. Currently, Iran imports power from Turkmenistan is building its first geothermal plant, is starting to use biogas and wind power.

Iran is seeking foreign investment from China, Thailand, Hungary, and has implemented legislation to encourage foreign investment . They've also started work on an underground gas storarge facility to safeguard their ability to store slack capacity and are planning a gas pipeline to India and Pakistan and are investing $24 billion in the development of the petrochemical sector so as to boost its contribution to GDP from 1% to 4%.

It has revamped its foreign investment laws and is now giving more scutiny to buyback contracts which are a legislative mechanism to keep sovereign control of the oil.

The Iranian constitution prohibits the granting of petroleum rights on a concessionary basis or direct equity stake. However, the 1987 Petroleum Law permits the establishment of contracts between the Ministry of Petroleum, state companies and "local and foreign national persons and legal entities." "Buyback" contracts, for instance, are arrangements in which the contractor funds all investments, receives remuneration from NIOC in the form of an allocated production share, then transfers operation of the field to NIOC after the contract is completed. This system has drawbacks for both sides: by offering a fixed rate of return (usually around 15%-18%), NIOC bears all the risk of low oil prices. If prices drop, NIOC has to sell more oil or natural gas to meet the compensation figure. At the same time, companies have no guarantee that they will be permitted to develop their discoveries, let alone operate them. Finally, companies do not like the short terms of buyback contracts.

This loosening of foreign investment restrictions is occuring at the same time that Iran is recognizing capital shortages in the electricity market, considering privatizing the sector, importing 45% of domestic gasoline consumption, which is growing at 10% per year ( four times the world average) and encouraging the development of natural gas powered vehicles so as to cut down on gasoline imports while at the same time its domestic natural gas consumption is falling.

The common thread that weaves though all of these reports is a desire to increase structural foreign currency earnings. If Iran abandons it's nuclear ambitions, which it has harbored since the 1960s and accelerated in the 1970s with contracts for 4 plants, a gas diffusion uranium enrichment plant, and plans for 20 plants by the end of that decade, it will have to replace that foregone power generation with other means. The obvious choice is of course it's oil and gas reserves. The dilemma for the Iranians is one of opportunity cost, for by diverting the oil and gas for domestic consumption they'll be foregoing earning foreign exchange, which if we discount the recent run-up in oil prices, Iran is in desperate need of, for oil is the main export that they have to offer the world.

Further compounding the issue is the rise of domestic consumption, and with its burgeoning population Iran could expect to see the majority of its oil production diverted away from export markets and severely curtailing its foreign exchange earnings. In one sense it could become like the US - a big producer of oil yet also a net importer as well.

An incomplete solution to the nuclear question was offered by both Senator Kerry and the Europeans in which the nuclear fuel would be sold to the Iranians thereby obviating the need for a domestic fuel cycle infrastructure. The strucutural flaw (ignoring for the moment the Iranian's nuclear weapons ambition) is that the nuclear fuel would have had to be paid for with scarce foreign exchange reserves. By developing a domestic fuel cycle, they exempt the whole sector from foreign exchange concerns.

Another compounding issue is that Iranian national pride is tied up with the nuclear development. To succumb to US and European pressures would be hugely unpopular domestically.

I can't see that the Iranians will ever abandon their ambitions for nuclear power and subsequently rely on their oil and gas reserves for electricity generation. For them to import their nuclear fuel and abandon the domestic fuel cycle they need to turn their acquiescence to Western demands into a domestic win and they need to offset their foreign exchange losses. How a win for the Iranians is engineered can be arranged amongst the many interested parties.

Absent any moves in this direction we would most likely see a period of UN sanctions that would free the Iranian hand, initially invigorate the population, and most likely speed up development with the aim of providing a fait accompli to the Security Council and then seeking an accomodation like those offered India, Pakistan, and Israel.

If the Bush Administration holds to the line that Iran abandon all of its plans for nuclear power, Iran will face a future a few decades out in which all of it's oil will be needed for domestic consumption, and it's already decreasing GDP/capita figures will really hit the basement. That's structural economic suicide for the Iranians (not that the Theocracy hasn't speeded them on their way.) Such a strong demand sets us up for a confrontation for I can't see the Iranians slitting their own throats.

Perhaps a more fruitful path can be followed by the US adopting a strategy of stalling Iranian progress while at the same time massively undermining the Iranian government. During the run-up to the Iraq War we were able to buy off Iraqi generals and other top officers. What we need is a regime change in Iran, a popular uprising and we need to provide the incentives (bribes) to initiate the process. Further, if the Mullahs are deposed, we need to provide favorable trade terms, or even trade assistance, so that the Iranians can diversify their economy away from oil and link the aid and cooperation to the importing of the nuclear fuel and the complete abandonment of the fuel cycle infrastructure. Afterall, when Iran was under the rule of the Shah, we had no issues with the prospect of 20 nuclear plants operating within Iran.

The Iranian nuclear problem really lies with the Mullah's weapons ambitions and what they will do with the bomb considering their biligerant foreign policy and active sponsorship of terrorism. The power plants are inevitable and if we demand their abandonment then we're on the path to war. We need to surgically target the real problem - the Mullahs.

Posted by TangoMan at 03:09 AM