Tuesday, February 02, 2016

Post-Sanctions Iran and Oil Markets

I wrote the following piece originally for IRNA, the official news agency of the Islamic Republic of Iran, on 22 January 2016.

Since the end of 2015, both international crude oil benchmark prices, US West Texas Intermediate and UK Brent, lost more than 20% and expectations are that this decline will likely continue at least until mid this year because of a simple reason. Severe oversupply and weak demand unite to reduce oil prices.

In its latest oil market report on 19 January 2016, the International Energy Agency said the world could face an estimated excess 1.5 million b/d (barrels per day) of crude supplies in the first half of 2016. The same day the International Monetary Fund revised its global growth forecast downwards by 0.2 percentage point, to 3.4% for 2016, due mainly to a weaker pickup in emerging market economies and a weaker-than-expected US expansion than was forecast in October 2015. This means that supply demand imbalance can be expected to widen. In other words, the excess could be even more than what the IEA estimates. In its report the IEA’s answer whether the oil price could continue to fall was “an emphatic yes”. Today, it would perhaps use a stronger phrase.

Already weakened markets cannot absorb new supplies. Iranian exports will most likely add to already oversupplied world oil markets. The US and EU lifted key sanctions against Iran in January, removing constraints that have capped Iran’s oil exports at 1 million b/d over the past four years. Iran’s return to the oil market brings three main questions forward: Quality, quantity and timing of oil that Iran can and will offer to the market.

 How much Iran can ramp up its production and export is a debated issue. It is yet to be seen whether Iran will boost its output by an immediate 500 kb/d plus an additional 500 kb/d within six months as was proclaimed by Iranian officials. What is clear so far is that Iran will have to reduce its big piles of condensates stored at sea. This might be not as easy as thought previously because current market conditions may make it difficult to market.

In fact the delicate issue is not so much about the quantity of additional Iranian oil could be flowing to world markets or the quality of it, but what kind of policy Iran will be aiming for inside OPEC and in international markets.

Inside OPEC Iran, who was the second largest producer inside the organization before sanctions, may fight for its desired place in terms of production capacity and quota. This would create another tension between Saudi Arabia and Iran who are already not in good terms due to their contrasting policies in the region. This means that Saudi Arabia and Iran will unlikely to agree on anything within OPEC.

 It seems that Iran will try to regain its market share in Euro-Mediterranean market by offering attractive terms if necessary and hence compete directly not only with Saudi, Iraqi and Russian oil but also with the US oil. It should be noted that after restrictions were lifted on the US crude exports, now US crude will compete with others. The first US oil tanker arrived in Europe on January 20.

 On the demand side, growth has remained fragile because of weak economic sentiment in major emerging markets as well as in some advanced economies, the expectation of rising interest rates in the US dampened indirectly economic growth and slowed the increase in oil consumption, mild winters in major oil consumers which undercut seasonal demand for heating oil, shrinking subsidies in some markets which sharply increased fuel prices, and a strong US dollar which has also exerted downward pressure on crude oil.

 A combination of new supplies to already oversupplied market and weakened markets due to sluggish demand growth will lead to an increasing inventory builds and hence put more pressure on prices to go down. At least this is the case for the physical barrel market. Current market fundamentals and expectations of traders about the future are reflected in the prices in the paper barrel market, where many other factors which are not directly related to oil market fundamentals come into play. When looked at this angle, it would not be surprising that oil prices declined along with declining stock market indexes worldwide. The daily average traded volume during December in Nymex WTI and ICE Brent crude futures was equivalent to around 1.5 billion barrels, 16 times more than the daily world oil production. Currently the paper barrel market is in contango (whereby near-month futures are cheaper than those expiring further into the future).

 So, what should Iran do in this highly volatile price environment? Flood the market with additional oil which makes the over-supply situation worse, and let the oil prices, which trade near a 12 year low, slide further? Insist on bringing an extra 1 million barrel per day of oil into the market within this year, and hence cause further irritation in the paper barrel market?

Maybe the first thing Iran should do is to avoid aligning with the Saudi oversupply strategy. That strategy was supposed to pressure Russia and other OPEC members, cause delays in large conventional upstream projects, crowd out higher-cost producers from the market and at the same time preserve its market share even with low prices. Instead, it helped brining the oil prices below $30 per barrel. Seen from this perspective, what Iran should not do is to significantly increase its production before selling its stored oil and get into a price war with Saudi Arabia.

 It is better for Iran to think long term: invest today in future production capacity and aim to sell the oil at the highest possible price possible. In the short term this translates into increasing oil production only gradually and giving priority to the stored oil for exports. Equally important Iranian officials should speak with one voice, and avoid making statements that would create further negative sentiment in oil markets. Last but not least, time has come for Iran to be more active inside OPEC. Iran should help setting a new course for the organization which is in danger of becoming irrelevant.