18 May 2018

Despite frenetic diplomatic efforts, including the evident bonhomie between Presidents Macron and Trump, the United States has withdrawn from the Iran Nuclear Deal (JCPOA).  The world awaits details of America’s new approach to confronting Iran’s nuclear ambitions and its aggressive regional political behaviour.   The Trump Administration has announced already its intention to re-impose sanctions over the next six months, including secondary sanctions on third parties doing business with Iran.  While European leaders (especially Germany, France and the UK — the E3 — who helped negotiate the Plan) remain committed to the JCPOA, they share America’s concerns about aspects of Iranian policy.  Prior to the November deadline for the re-imposition of sanctions, the  E3  will attempt to assuage American concerns and preserve the Agreement.  However, as I suspect these efforts will prove futile, Europe seems increasingly likely to comply (albeit reluctantly, unhappily) with the new sanctions regime, which could signal the end of the JCPOA for practical purposes.

Oil prices have already risen 60% since last Autumn partly in anticipation of the possibility of reduced energy supplies. Markets will need to answer several key questions.  What will be the medium-term impact on oil prices? What impact will sanctions have on the Iranian economy, and subsequently on Iran’s political behaviour? Former US President Bush famously linked Iran and North Korea as part of an “axis of evil”.  Strategically, however, the two countries differ in important ways.  In particular, Iran has considerably greater resources — both financial and natural — at its disposal than North Korea.  Consequently, markets and policymakers must be prepared that even a successful campaign of containment will play out over many years, if not decades.

Oil Markets:  Who Picks Up the Slack?

In response to the earlier price collapse, OPEC and key non-OPEC countries agreed to cut 2017 oil production by roughly 1.7mbd (million barrels per day): 1.2 and 0.5mbd for OPEC and non-OPEC respectively. The aim was to reduce bloated  inventories by re-balancing  world-wide oil supply and demand. Chart 1 shows the huge progress made in lowering stockpiles since 2016.

This achievement reflects widespread compliance with the agreed production cuts (Chart 2 above). However, beneath the headline success, individual country behaviour has influenced the market’s supply dynamics. Since last September, which has coincided with the sharp rise in oil prices, OPEC output cuts have exceeded the target by roughly 50%, or 0.7mbd.  Virtually all of this shortfall emanates from an involuntary collapse in output in Venezuela (next chart).  Smaller out-performance  occurred in Saudi Arabia, Angola, and, Algeria (roughly 0.1mbd each). Iran is not party to the accord, but following the lifting of sanctions in 2016 output rose roughly 1mbd — quickly regaining its pre-sanctions production level.

The first Chart illustrates that non-Opec compliance has been less consistent — overshooting its target by about 10% each month (0.1mbd) — with Kazakhstan the main culprit. Important to the plan’s success has been Russia’s participation and compliance. While not involved in the program, the United States is the biggest wildcard in the effort to restore the market’s balance. And, the following Chart shows that while others have been reducing supply, continued double-digit US production gains have taken market share from Saudi Arabia, now exceeding the Kingdom’s petroleum output.

Overall, world-wide oil supply has declined modestly during the period of the OPEC agreement: Opec cuts offset by rising US production.  Meanwhile, the key factor in restoring balance in the oil market has been the synchronised acceleration in global economic activity, which has lifted world-wide oil demand by over 5% during this period. The combination of rising demand and stable supply has produced the desired lower inventories.

At this stage, therefore, it is impossible to determine whether Iran or Venezuela has played a larger role in the recent rise in oil prices. Nevertheless, if sanctions again do cut Iranian oil production by 1mbd, who will pick up the slack (in addition to the 0.5mbd lost in Vennie)? Will the OPEC accord survive (it’s due to expire in December), especially if the USA applies pressure to boost production? The June OPEC meeting will be vital. The US EIA estimates Saudi Arabia has the capacity to increase production up to 2mbd. Saudi Arabia will be encouraged by the more balanced oil market, but the Kingdom is benefiting from the higher oil prices. On the other hand, the Saudis would be pleased to steal market share from Iran.

Overall, I expect OPEC in June  may signal a willingness to curtail its production cuts next year — adding up to 1.2mbd to global supply — IF Iranian output declines prior to the November sanction deadline. The rest could come from the USA or Russia, although Russia is benefiting from high prices. While long-term fundamentals favour an era of lower oil prices, current uncertainties along with tigher supply/demand dynamics are likely to boost quotes through the end of the year (WTI should exceed $80+).  However, if OPEC does end its production cuts, oil prices should again return to previous ranges in 2019.

Do Sanctions Work: You Can’t do it Alone

There is broad consensus that sanctions can significantly impact economic performance, but only if there is wide and persistent compliance.  Iran itself provides an excellent example.  Ever since the 1979 revolution (and the subsequent hostage crisis), the United States has imposed varying sanction regimes on the Islamic Republic. However, the Chart indicates that these efforts have been unsuccessful in preventing the post-revolution recovery in oil production and exports.  This pattern continued even following additional UN sanctions during the 2000s in reaction to  pickup in Iran’s nuclear activity.  Only after a toughening of US efforts in 2011 — and crucially the participation of European allies in 2012 — did the sanctions bite.

Under past sanctions regimes, the Chart above indicates that the trend in Iran’s per capita GDP tracked in line with Turkey and MENA, and outperformed Saudi Arabia and Mexico.  Between 2011 and 2015, however, output per person declined 10-15% (split evenly between population gains and GDP losses). Meanwhile,  oil production and exports collapsed 25% and 40% respectively during that interval. Following the lifting of sanctions in 2016, GDP as well as oil output and exports have recovered previous losses.

During the recent sanctions period, the exchange rate depreciated 40%, and inflation soared from 10% to nearly 50% (Chart above). The lifting of sanctions led to relative FX stability, and inflation returned to 10%. Recently, uncertainties resulting from Iran’s 2017 election, recent street protests, and President Trump’s election have led to another 40% Rial dive.  In addition, the black market rate has decline an additional 50%. This time, inflation could reach 100%.

Previous sanctions virtually eliminated Foreign Direct Investment, which was never huge (above).  The lifting of sanctions has not produced renewed inflows, despite considerable negotiations on energy projects.  Moreover, French energy giant Total has indicated it may scrap plans for gas sector development rather than risk the loss of business in the United States. Others appear likely to follow.

The Chart above illustrates the vital role Europe’s involvement played in the success of the recent regime — lower European purchases accounted for over 50% of the decline in Iranian oil exports.  Getting Europe on board will be an important ingredient to a successful containment strategy.  But, that will not be enough. Iran has made concerted (and successful) efforts to reduce its reliance on Western trading partners.  Europe’s share,for instance, has been cut in half since 2000. Now, China, India, and Turkey account for nearly 60% of Iran’s exports (Korea and Japan another 20%). Rather than risk the loss of American business,  Europe may well curtail trade and investment with Iran, but convincing China, India and Turkey may be far more troublesome.

Containment: In it For the Long Haul?

How Iran fares under a renewed sanctions regime will depend in large part on the performance of the non-oil sector, as optimists suggest that Iran’s economy is relatively well diversified.  The Chart suggests this is true to an extent.  Iran’s manufacturing sector is larger than in Saudi Arabia and most other Middle East nations, but is much smaller than Turkey’s and other emerging market regions.

Likewise,  non-oil exports represent only 11% of GDP, which is well below both many other oil-dependent nations, and well below manufacturing-oriented peers (Chart below).

Since the removal of sanctions in 2016, the non-oil area has expanded only at a modest 3% clip: not enough reduce double-digit unemployment.  The World Economic Forum has identified key reform priorities to jump-start this part of the economy: the banking system, labour market, infrastructure, and government corruption.  Correcting these shortcomings will not be cheap or easy.

As a result of government-mandated lending, bank non-performing loans represent 13% of assets compared to 3% in other Gulf nations.  Bank capitalisation ratios have declined sharply (see Chart), and financial sector recapitalisation is a key (expensive) budgetary priority.

Iran will face formidable fiscal challenges in the future, especially as sanctions are likely to slow economic growth. If Iran is to prevent a rapid rise in government debt, government priorities will need to change dramatically. Until recently, government debt has been low (Chart). However, bank recap costs and the recognition of huge government arrears has sharply increased public sector liabilities in recent years. Consequently,  interest costs on the debt stock are rising rapidly.  Meanwhile, public sector investment at 5% of GDP is less than half the level in Saudi Arabia.  Infrastructure needs and capital outlays in both the non-oil and oil sectors require much higher investment.  If sanctions slow growth sharply, government debt could rise towards 60-80% of GDP compared to just 10% in 2014 (manageable, but not desirable).

Iran’s high birth rate in the 1980 and 1990s is now leading to 2% labour force gains.  The following chart illustrates that even after sanctions ended, job gains have been insufficient to prevent further rises in unemployment.  Even by Middle East standards the level of youth and female unemployment is shocking!  The 10% female participation is by far the lowest in the region, if not the world.

High unemployment coexists with a highly educated workforce. The Chart indicates that college education levels has risen sharply, and are now the highest in the region.  As literacy is nearly universal and the gender gap in schooling has been virtually eliminated,  education can not explain the overall low labour force participation rate or the gender gap in pay and unemployment. Indeed, many students remain at university because there are no job opportunities. As in other Isalmic nations, educational achievement in maths and sciences is below the world average.

In the end, the health of Iran’s external balance sheet will play a key role in determining how long the nation could cope under a strict sanction regime.  Under past sanctions, Iran’s current account surplus declined by 8% of GDP (from a surplus of 10% of GDP in 2011 to 2%).  Assuming Iran’s oil exports now decline 50%  or roughly $30bn (which is extreme), the current account would swing into deficit of $15bn (3% of GDP), which would be another swing of 8% of GDP (the surplus is now 5% of GDP).  As Iran’s international reserves now stand at $150bn, this suggests the situation could continue for at least a decade! (Would be longer in reality as imports certainly would decline and non-oil exports rise).  If Containment is the strategy, markets and policymakers should plan for the long haul!

Strategic Implications

• Oil prices are likely to rise for the remainder of this year: WTI  should hit $80 per barrel.
• Political risks within Iran will grow. Some suggest that a weaker economy and high unemployment (especially amongst highly-educated youths) could lead to protests and demands for political liberalisation.  Perhaps more likely, President Rouhani could come under pressure from hard-liners to abandon his economic reforms (especially his perceived over-involvement with the unreliable West).  With the external environment worsening, hard-liners could push for an inward-looking, isolationist growth strategy — perhaps including a reconsideration of the future of its nuclear program.
• Political tensions between Iran and both Israel and Saudi Arabia have escalated.  And, while still remote, the potential for regional military conflict is also rising.