Iran Sanctions: Unanswered Questions

The U.S. has exited the Iran deal/become non-compliant and announced a timeline to reimpose the sanctions that had been suspended in 2015, as many people feared. Some key questions have been answered including the phase-in period, start of discussions with suppliers,  but many key ones remain unanswered. In this post, I’ll take a look at what we know, where some of the economic and market uncertainties lie and speculate on the impact on Iran’s economy and the oil market, updating my post from last week.

Key points

• Despite extensive OFAC guidance, implementation may be very confused with many key decision points coming up in upcoming weeks and many companies and countries looking for carveouts. The amount of diplomacy/planning with alternate suppliers and buyers of Iranian fuel or other interests seems to be much less than pre-2012, which could increase volatility and could negatively impact other regional and global interests.
• Iranian oil exports are likely to fall over the course of the coming months (perhaps by 300-500K barrels per day) and further in 2019. The nature of the Output (and export) levels are likely to remain higher than pre-JCPOA levels given relative lack of global consensus on the sanctions compared to the 2012 period. This trend will be negative for Iran’s economy and tighter policies to manage the impact of the FX depreciation may exacerbate the economic impacts. Iran may seek to increase non-oil exports to compensate, and cut imports,.
• Saudi Arabia and other OPEC members are likely to make implicit adjustments to offset any losses of Iranian crude but may do so at a slower pace and higher price than hoped. The Saudi preference for a Plus-$80/barrel price may suggest delays and increase costs for selected Asian and European refiners. This would imply greater oil market volatility and higher prices, a challenge for some consumers and selected importing nations with weak balance sheets (Turkey, India).
• Concurent (and fraught) negotiations on trade with China and selected EU countries as well as DPRK nuclear talks in this period of time may complicate implementation. The “busy and dangerous” May schedule includes not only key Iran deadlines, but also those on trade, which are adding to global growth concerns.

Critical uncertainties remain around the response of the Iranians and the other signatories of the JCPOA, notably those in Europe, who fought hard to save the deal and will now be put in the hard position of trying to maintain their commitments to Iran, their business interests and the fear of fines and pressure on U.S. links. Asian countries too, will be forced to rely more on government guarantees for trade with Iran (though this is not particularly new). On Iran’s side key questions concern whether they are willing to provide further discounts to fuel exports, what economic policies are enacted especially in the face of the continued FX pressure and what regional and domestic security policies are enacted.

That the decision to reimpose sanctions came as the U.S. and Europe were “close” to negotiating a fix brings a number of concerns. European partners may be less willing to continue negotiating with the U.S. as they look to protect their interests and their energy supply chains in the 90 to 180 day implementation period making it more difficult to negotiate on multiple fronts. In some ways the announce the return of sanctions first, hope for a deal second, is consistent with some of the tariff policy negotiation under way in other issue areas. There are significant risks with this approach including a lack of clarity in what would constitute a “good” outcome.

How might it impact other oil producers and key buyers?

As should have been expected, Saudi Arabia has belated noted that they stand ready to provide fuel to offset losses from Iran. This is unlikely to be frictionless. Press reports suggest that Aramco was already targeting Asian and European refiners over the last few weeks/months looking to switch, though these changes may come more slowly and at a higher cost than buyers would refer. Indeed, they likely see the developments as a win-win – the potential increase in output (and revenues) at the same time that their Iranian rival faces losses. However not all in the gulf see the trend equivalently with several countries – Kuwait, Oman, Qatar (and even some of the Emirates like Dubai have more sizeable trade with Iran or interests in growing them. The imposition of sanctions may reflect or exacerbate regional. Anything that takes oil output offline or adds uncertainty of supply should be positive for price, adding to the upward swing and increasing revenue.

Iran’s response matters too, especially via price. Moreover there remains the risk that Iran may look to maintain production via discounting (something it was notably reluctant to do too much in the leadup to the JCPOA given that middlemen would have captured the premium). Recent increases in exports (in April) may reflect a) some moderate discounting versus similar Saudi blends b) a desire to maximize revenues at a time of higher prices and c) desire to have a higher base of production before sanctions would be imposed.

It remains to be seen which of Iran’s current buyers will switch to other suppliers – European countries – France and southern European buyers who continue to be the major consumers – may look to maintain imports as part of their negotiations with Iran. Japanese and South Korean refiners, may be less motivated, especially given their long-standing ties with Aramco and some refineries/reserves partnerships. Moreover, with U.S. trade risks and concurrent negotiations with north Korea, they may be less willing to go on a limb for Iran. Note that imports never regained 2012 levels in those countries even as they revived in some European countries, Turkey, China and India.

Another question surrounds how any of Iran’s revenues will be saved.  the unpopular accounts system for payment is re-established. In this system. Countries received a waiver against sanctions if they reduced trade with Iran and segregated earnings in locally domiciled accounts (in local currency – TRY, CNY, INR, KRW etc) for approved goods. Iran became even more a price taker in this scenario.

Key buyers of Iranian crude already tend to have government entities and financing guarantees in place to facilitate transactions as global banks have been reluctant to take on the sanctions, money-laundering and counterparty risks with their Iranian counterparties. These suggest that some of these vehicles (India, China among others) may continue to operate, especially if they can negotiate discounts with Iran. Expect an increase in trade in local currencies and possibly some barter organizations. All of these trends suggest that global consensus on cutting output will be much lower than in the early 2010s.

What might the impact be on Iran’s economy?

 The outcome is definitely growth negative for Iran, through the channel of lower oil production, and increased capital outflows. Losses of up to 500,000 barrels per day in oil output would have a meaningful drag on Iran’s economy, contributing to a significant growth slowdown and (near) recession, particularly if they are accompanied by tighter fiscal and monetary policy due to efforts to stabilize the currency, which has continued to fall sharply. Foreign investment was relatively low, but now is much less likely to materialize. The saving grace is that foreign inflows and debt levels remain relatively low.

Sizeable cuts in oil output would be negative for growth, with continued high(er) oil prices a moderate offset. An average of commentators estimates output reductions of 250-500K barrels a day by the end of 2018 and somewhat more in 2019 as pressure increases to show further declines and put additional pressure on the economy by cutting inflows and leaving Iran as a price taker in global markets either in terms of its oil exports or in terms of its imports as these become more difficult to finance. In the 2011-15, Iran was very much at the mercy of its trading partners in terms of the value of goods being provided in exchange for oil.

Oil production and related revenue has been a major part of Iran’s economic revival, as fiscal and monetary policy remained constrained, being only moderately expansionary. Average wages have been slow to climb and bank balance sheet vulnerabilities kept local credit restrained. These trends including the vulnerabilities of the non-bank financial system contributed to the wave of protests over the last six months.

The move is likely to embolden those in Iran who focus on the resistance economy and look to restrain imports and avoid foreign debt and disempower any pragmatists, which were slowly working on reforms. Local efforts to reduce reliance on imported fuel (refined products) provide some resilience. It remains to be seen how some of this pressure might impact security interests.

Major trading partners including Turkey may be particularly vulnerable to the concurrent increase in fuel imports and decline in Iranian imports.