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Richard Robinson Fund Manager

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Crumbling Iran nuclear deal a potential game-changer

16 Aug 2018
Following years of heavy criticism, United States President Donald Trump ripped up what he referred to as a “decaying and rotten deal”, pulling out of the Joint Comprehensive Plan of Action between Iran and the P5+1 (China, France, Russia, the United Kingdom, the United States and Germany), plus the European Union.
This decision came as no major surprise considering the rhetoric and conduct of the President, who geared up to the decision by replacing Secretary of State Rex Tillerson and National Security Advisor HR McMaster with Iranian hardliners Mike Pompeo and John Bolton. However, the announcement went much farther than was expected and was essentially a full withdrawal from the deal, with no room for further negotiations. France and the United States, in particular, could face a tricky decision in the upcoming United Nations decision during the meeting. If Iran refers the United States to the United Nations over its violation of the deal, then the United States could face a vote that (if it goes against them) risks isolating the country and embarrassing Trump on the world stage. It appears that bargaining chips are up for grabs, particularly in light of Trump’s trade war negotiations. Notably, in mid-May the United States softened its stance on the high-profile trade war with China. 

What does this mean for the oil market?

The worst-case scenario outcome of this move, one which involves strict adherence and policing of sanctions, could see as much as
700 000 barrels per day (bbl/d) removed from the market. A less disciplined approach, with more ambiguous United States guidance, could remove less than 200 000 bbl/d. However, Trump’s rhetoric sounded fairly unambiguous, so a bigger impact must be expected.

Although Trump would ideally have liked Europe to join him in re-imposing sanctions on Iran, the eventual effect is likely to be similar nonetheless. Europe currently imports between 500 000 and 600 000 bbl/d of Iranian crude and it is expected that this number will drop
by approximately 60%. Iranian barrels can be fairly easily substituted for Iraqi crudes. 

European companies that are present in both Iran and the United States, such as Total and Eni, may also choose to stop lifting Iranian crudes altogether, for fear of being precluded from the United States market. It is expected that Asian refiners, with exposure to both regions may also choose to follow the ban. China, on the other hand, may choose to take advantage of the widening discounts and purchase more Iranian crude (through various shell companies). The other potential supply ‘dampener’ could involve moving Iranian crudes through Iraq as they did with roughly 200 000 bbl/d ahead of the lifting of sanctions. 

Lost oil is only part of the story

Britain, France, Germany and the European Union have made it abundantly clear that they would view a re-imposition of oil-related sanctions as a violation of the nuclear agreement. That said, it is highly unlikely that the deal will continue without the participation of the United States, so a complete collapse is probable. Although the Iranian government insists that the deal will endure, simply without the United States’ involvement, it is hard to see how it will survive. There is little reason why the Iranian government would continue to cooperate with inspections while European corporations are reducing their presence in Iran and the amount of oil that they are purchasing out of fear of financial reprisals from the United States. This is despite European legislation, enacted in the 1990s, that could protect companies affected by United States sanctions. Ultimately, however, a choice for corporate Europe between the United States and Iran is unequivocally going to fall the way of the United States.
 
If Iran did decide that its interests were best served by kicking out all inspectors, ripping up the nuclear non-proliferation treaty and pursuing the object of building a nuclear bomb, then we could be in for an even more turbulent period than we are already seeing in the Middle East. Estimates vary, but the UN monitors suspect that Iran is less than 12 months away from achieving that very objective. 

Whatever the response, the impact is unlikely to be immediate. For those with existing contracts, they will have between 90 to 180 days to terminate. Iranian exports are likely to face a slow bleed lower, as Iran find cargoes become increasingly difficult to secure. Although this decision has been well broadcast and the short-term pricing response may be flat or even negative, the implications for the market fundamentals are bullish, even if the escalating risk premium that we are likely to see in the future is ignored. The market can hardly afford yet more oil to be removed from an already tight and tightening outlook.
 
We were and remain bullish with regards to the oil price, even prior to the prospect of Iranian crude being removed. The rate of decline in inventories over the last 12 months has been unprecedented, despite the phenomenal growth in supply from the United States onshore market. This supply growth has been eclipsed by a combination of very strong demand growth - which was far above the International Energy Agency’s forecast at the beginning of the year - and due to supply being driven lower in a number of countries, most notably Venezuela.
 
In 2019 we will also see the start of a sequence of years where the number of projects delivering first oil declines significantly, thanks to the precipitous drop in project spending between 2014 and 2017. 

The actual impact on Iran domestically could also be significant. This point is unlikely to be lost on the Trump war office, and regime change could well be the United States’ intended end game; a point which Rudy Giuliani, Trump’s latest attorney and the former mayor of New York eluded to in a telling remark in early-May that Trump is “as committed to regime change as we are”. If regime change is indeed the intention, then there will be little that can be done to salvage the deal.
 
Trouble at home

Iran has recently seen an alarming pick up in public dissent, with 22 people killed and almost 500 arrested in street demonstrations that lasted several weeks during January 2018. Over the past few days, teachers, bus drivers, steel and rail workers have been on strike across the cities of Ahvaz, Tabriz and Tehran. These are just a few examples of the hundreds of recent outbreaks of social discord felt across the country in recent months. 

In 2015 the Iranian government promised that lives would be made easier once sanctions were lifted in early 2017. Despite these promises Iranians have been feeling increasingly frustrated by a lack of improvement in their personal circumstances, and are feeling ignored. The level of frustration is compounded by the fact that billions of dollars of potential domestic spend has been, very publically, diverted to fund Iran’s regional conflicts in Syria, Lebanon, Palestine and Yemen.
 
Hardliners have been pushing for an Iranian airbase to be installed in Syria, something that the Israelis and their allies would be keen to prevent. The prospect of an Iranian airstrip in a bordering country could have acted as an accelerant to re-imposing embargoes. An Iranian airbase in Syria would cost hundreds of millions of dollars, and looks less likely to be undertaken following the re-imposition of sanctions and the potential economic strangulation of Iranian hegemony in the region. 

Tough choices

Iran is facing some tough and potentially fractious decisions. The regime must either focus its holed budget domestically, concentrating on survival but in the process handing over the initiative to the Sunni-led Saudi influence, or continue to spend on regional conflicts and risk another revolution at home. Iran’s third choice involves renegotiating the deal (however they will surely have their regional aspirations clipped in any subsequent agreement). Either way, the Middle East will continue to be an area of extreme geopolitical risk, the likes of which some say, we have not seen since the start of the First World War.
 
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