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Iran, sanctions and crude oil prices

The prospect of a US-Iran diplomatic rapprochement, while remote, cannot be ruled out.

The global economic implications are immense since a deal on Tehran and its nuclear weapons programmes rules out the prospect of an Israeli or US air strike that escalates into a wider Middle East war.

For Iran’s Ayatollahs, a deal with the US means the West is no longer perceived a threat to the theocratic regime’s survival and the end of US, EU and UN sanctions that have caused a plunge in oil exports, currency collapse and mass economic distress. Washington’s nuclear deal with Iran could also mean the prospect of a negotiated settlement in Syria and political stability in Lebanon. Egypt will benefit from Iran’s influence on Hamas and its Bedouin tribal militants in the Sinai. International relations are rarely a fairy tale but a US-Iran nuclear deal will match Nixon’s/Kissinger’s epic trip to China or peaceful end of apartheid in South Africa.

Oil has been the lubricant behind the Shah’s meteoric rise to global power in the 1970s, and oil riches hastened his eventual fall. The path to a nuclear deal Geneva will be a game changer in world affairs. Both Congress Republicans and Revolutionary Guard hardliners will bitterly oppose an Obama-Rouhani deal. Another million barrels of Iranian crude in an end to US naval patrols in the Gulf and the Straits of Hormuz, better relations with Saudi Arabia and the GCC, mean an epic fall in geopolitical risk in crude oil markets.

Two years of US and EU sanctions on Iran oil exports, as well as restrictions on bank financing, shipping and insurance, could potentially be reversed if the US-Iran negotiations are successful (a big if, I concede). Iran produced 4mbd in 2010 and its latest August 2013 output data was a mere 2.57mbd. Can the global energy markets absorb an extra 1.5mbd of Iranian crude without a major price fall or Saudi Arabian/Opec output cut? No. Is there any realistic short term prospect of a spike in Iran crude exports to its traditional refinery clients in India, China and Southeast Asia? Absolutely not. The greater longer term impact of Iran’s emergence from international pariah state status could be the technological upgrade of its energy infrastructure and loading terminal in Khang Island, degraded after decades of revolution, war and neglect. This is the reason global hedge funds have sharply reduced their net long West Texas futures speculative positions on the New York Mercantile Exchange. The Syria chemical weapons accord, Libyan’s increase in oil exports, falls in global stock markets, the Italian political crisis and the US government shutdown were all bearish for crude oil prices last week.

If financial markets realistically believe Iran will re-emerge as a major global oil and gas exporter, West Texas could fall to $90 or even lower. This is an unwelcome prospect for Saudi Arabia, whose budget break-even price has risen to as high as $95 Brent after the kingdom’s social welfare spending soared. So it is entirely probable that Saudi Arabia will engineer an Opec output deal to prevent a price glut, as did in 2009 after the twin shocks of the Lehman failure and the global recession.

Saudi Arabia knows all too well that Iran is a potential energy superpower, a nation with the world’s fourth largest oil reserves that once pumped 6mbd in the final years of the Pahlavi Shah’s era. In any case, Iran’s production only fell to 2.57mbd because the EU embargo made it impossible to store, trade or export its crude. So a quick return to 4mbd, as pledged by Oil Minister Bijan Zangeneh, is all too possible if Western banks once again lend to Nioc and Western oil services companies can upgrade its reservoirs and oilfields. Iran is desperate for hard currency since its exports have now fallen to a minuscule 700,000 a day and the lifting of sanctions could easily cause a 1mbd surge in production. This is only the tip of the ice berg since Iran was traditionally the Opec’s second-largest producer.

Iraq’s return to the oil market under the 1997 UN Oil for Food Programme coincided with a catastrophic fall in oil prices, through in 1998 also coincided with the Asian currency crisis and the Russian rouble default. With US shale oil at 7.5mbd and Saudi Arabia producing at or near full capacity, the prospect of $80 Brent could become a ghastly macroeconomic scenario for the Opec, Mexico and Russia. Below $80 Brent, a huge proportion of the world’s high-cost oil (deep-water Brazil, Russian Artic, Canadian oil) becomes uneconomic. So Iran’s return to the world oil market has the potential to trigger a glut and price crash.