(Adds details and background)
By Luke Pachymuthu and Nidhi Verma
SINGAPORE/NEW DELHI Oct 24 (Reuters) - Iran's state oil refining firm and India's Essar Group are expected to start building a 300,000 barrels per day (bpd) refinery in southern Iran early next year, sources close to the deal said.
The facility, estimated to cost $8-$10 billion and which would be the first foreign-invested downstream project in sanctions-hit Iran, will boost the OPEC member's stagnant refining sector that is struggling with petrol shortages.
Once finalised, it will be Essar's first overseas refinery development and will provide a foothold to the family-owned Indian business house in Tehran, where it is also trying to build a steel plant and acquire exploration assets.
The proposed plant at the southern port town of Bandar Abbas, will process heavy crude such as Soroush and Iran Heavy to be allocated by the Iranian authorities.
"We have completed the feasibility study and now, we are working on the project financing, and we have targeted starting on the construction phase next year," a Tehran-based source from the National Iranian Oil Refining and Distribution Company said.
The refinery could take three to four years to build, the source added.
Essar, owned by the Mumbai-based Ruias family, will take a 60 percent equity stake in the project with Iran taking the rest, said the Tehran-based and India-based sources.
"The priority of the new refinery will be to meet domestic gasoline and diesel requirements, and we will export the surplus products," said an India-based source familiar with the deal.
Ravi Ruia, Essar Group's vice-president responsible for the firm's overseas venture and his officials are now in Iran to take the issue forward.
"If discussions are finalised, then work can begin early next year," the Indian source said.
An Essar spokesman declined to comment on Ruia's visit and the company's interest in Iran.
Iran, the world's fourth-biggest oil exporter, last year launched a multi-billion dollar, five-year plan to expand and upgrade its refineries to 3.0 million bpd, from 1.6 million bpd.
But energy consultancy Wood Mackenzie estimated that Iran's actual refinery capacity additions would more likely come to 700,000-800,000 bpd by 2014 and cost at least $10 billion.
The country lacks refining capacity and imports massive volumes of costly motor fuel to meet domestic demand. This has become a sensitive issue, as the West considers tougher sanctions against Tehran's nuclear work.
Last week, Iranian officials were reported to have told local media the country was expected to import $4 billion worth of gasoline during the Iranian year ending in March 2008, suggesting a 20 percent drop from the previous year. Officials have said Iran spent $5 billion or more on imports last year.
Iran's access to financing of mega-projects have been hindered by tighter credit from European banks and Western energy firms' reluctance to do business with the Islamic Republic, depriving it of the expertise and technology needed for upstream projects.
But Iran has found support from companies in energy-hungry Asia, eager to participate in its refinery and energy infrastructure expansion plans in exchange for equity.
"As a heavy oil refinery, it is going to require a significant amount of conversion facilities to crack deeper into the barrel and treating units to deal with the high metals content of the crudes it will be processing," said Vijay Mukherji, a senior consultant at FACTS Global Energy.
Mukherji said Chinese and Indian firms such as Petrochina (0857.HK), Sinopec Corp (0386.HK), Reliance RLEN.BO and Essar are capable of working on downstream projects. "However on the upstream side, we believe Western technology and expertise is still required," he said.
Essar, a diversified, family-owned holdings company with interests from telecoms to construction, also plans to set up three steel plants in the Middle East, including a joint venture to build a 1.5 million tonnes a year steel plant in Iran.
In January, an Essar official told Reuters the company wanted to strengthen its relations with Iran and was looking to buy into Iranian exploration and production blocks to help meet electricity needs for its planned steel plant.
India's oil minister Murli Deora said in March that Essar Group is in talks to buy liquefied natural gas from Iran.
Essar is also discussing with Iran to jointly develop the giant Azadegan field, the Middle East country's biggest oilfield with in-place reserves of 26 billion barrels.
Japan's INPEX Holdings Inc (1605.T), which holds a 10 percent stake in Azadegan, was slated to develop the field but the deal fell through last year.
Essar has also submitted a bid for three exploration blocks in Iran in the most recent auction round.
Its oil refining arm Essar Oil Ltd (ESRO.BO) launched India's second private-sector refinery late last year and the group plans to raise its total refining capacity to 680,000 bpd by 2010.