Today, President Trump is expected to announce his decision on whether or not to exit the Joint Comprehensive Plan of Action with Iran (colloquially referred to as the “Iran Nuclear Deal”), ahead of the May 12th deadline to extend waivers for sanctions on Iranian exports. The suspension of these sanctions began in 2015 after then-President Obama negotiated the deal, meant to create strict restrictions on the country’s nuclear program. Trump, however, has long speculated that Iran has continually violated the deal, and promised in his campaign to withdraw the US from the agreement. There is a possibility that European signatories could save the accord by fixing what Trump calls “flaws” in the deal, but judging by the haste with which he is acting, it seems unlikely.
If the US does reenact the sanctions, the impact will be palpably felt in oil markets. When sanctions were initially implemented in 2012, Iranian oil output fell 60% from 2.5 million barrels per day (b/d) to 1 million bpd. This time around, Iran is currently producing about 3.8 million barrels a day, and the drop in supply could range anywhere from 500,000 to over 1 million b/d. While the impact on Iranian oil production may not be not as significant as 2012, global oil markets are already facing an average deficit of 700,000 b/d and the lowest inventory figures in nearly 4 years.
Spare capacity, the volume of oil that can be brought into production within 90 days and sustained for an extended period, is already tight. Almost all of the 200,000 to 310,000 daily barrels of spare capacity in Iraq reflects production in the north of the country that has been shut in as a result of the ongoing dispute between the federal government in Baghdad and the Kurdish Regional Government. A further 500,000 b/d of combined Saudi and Kuwaiti idle capacity lies in the fields of the divided Neutral Zone, which Saudi Arabia closed on environmental grounds in 2015.
Saudi Arabia could reopen these, along with other idle supply, raising output to 11.5 million b/d immediately. In 6 to 9 months, the total output of Saudi Arabia could be 12.5 million b/d. Since the kingdom has never produced more than the 10.63 million barrels a day and has indicated an interest in stabilizing oil prices, this scenario will probably not happen.
The IMF recently stated that Saudi Arabia needs to continue “structural reforms,” largely referring to the Vision 2030 plan spearheaded by crown prince Mohammed bin Salman. New taxes, deficit reduction, labor market reforms and investments in non-oil sectors of the economy are crucial. Most importantly, oil prices are still too low to fully balance the books. The IMF claims that the Kingdom needs about $88 per barrel to balance its budget, up sharply from $70 per barrel last year. Some speculate that the Saudis actually want oil even higher than that, in upwards of $100 per barrel. Given their interest in higher oil prices, as well as an ongoing diplomatic freeze with Iran, it is unlikely that Saudi Arabia would push for any serious increase in production to offset potential losses. Especially since the nation has only kept cutting its production even though production from Venezuela, Angola, and Libya has fallen.
What should be even more worrying for Iran are developing symptoms reminiscent of Venezuela. Since December 2017, Iran’s currency, the rial, has lost one-third of its value as inflation continues to surge. On April 10, the exchange rate’s rapid depreciation prompted the government to halt domestic foreign-exchange transactions and outlaw foreign-currency holdings of more than $12,000. Even though the Iranian economy has generated 600,000 jobs a year since the nuclear deal took effect in 2016, unemployment is still running at an all-time high. According to the 2016 census, among college-educated 20-29-year-olds, 36 percent of men and 50 percent of women are unemployed. Crude oil and petroleum products make up more than 60% of Iranian export revenue and a large proportion of the state budget. If reintroduced sanctions on this powerful industry worsen these conditions, ensuing political and economic turmoil could threaten output even further.
Oil sanctions on Iran would push global oil prices higher, lending further support to several MRP themes including Long Oil & U.S. Energy, Long Energy Services & Equipment, and Long Saudi Arabia, which we added as a new theme yesterday. Higher oil prices would get Saudi Arabia closer to balancing its budget, while increasing investor interest in the Saudi Aramco IPO, which is an important piece of the kingdom’s economic revamp story. As for energy services and equipment companies, they would benefit from a pickup in exploration and drilling activities that would occur once E&P companies become more confident that higher oil prices lie ahead. The developing Iran story compels us to reaffirm our price target of $60-$80 per barrel on WTI crude, which we set in April 8, 2016 report: Implications of the Coming Shortage of Oil.
Investors can gain exposure to the themes mentioned via the Oil ETN (OIIL), Energy ETF (XLE), Oil Services ETF (OIH), and Saudi Arabia ETF (KSA).