U.S Iran Accord; Impact oil Futures

Edited by Vani Rao

Oil Prices Jittery After Iran Nuclear Deal Announcement

Oil prices plummeted after the announcement of a nuclear deal between the world powers and Iran. The UN Security Council along with Germany and Iran have struck a six-month interim agreement, in which Iran will limit its nuclear program in exchange for an easing of international sanctions that will provide Iran with $6-7 billion of relief on some sectors including precious metals. Reacting to this development, the Brent crude fell nearly $3 per barrel, but it soon bounced back to its previous level of $110.96 by the end of the session on Monday. However, the news of easing the sanctions on Iran had little impact on West Texas Intermediate, the US benchmark crude. It fell just 66 cents since the agreement was announced.

Source: Bloomberg
Source: Bloomberg

Industry experts perceive this trend to be more of a knee jerk reaction from the markets. As details emerge, we have tried to analyse how the deal impacts the oil prices future.

Short-term impact

The US Government insists that sanctions on Iran’s oil and banking sectors remain in place and that the international community will “continue to enforce these sanctions vigorously.” These sanctions have been successful in squeezing Iranian exports, which have fallen from 2.5 million barrels per day (bpd) in 2012 to 715,000 bpd to date , a loss of nearly 2% of the world crude output. Iran will still be “be held” to sell only upto one million bpd in sales. This may not be a significant change, but it will result in Iran’s exports declining further at least for the time being.

On another note, under the accord, the Obama administration will ease pressure on allies to continue cutting their purchases. In recent years, the US has been pressurizing countries such as China, India, and Japan to stop buying oil from Iran, which could result in a huge inventory pile up, thereby lowering oil prices.

Psychological price

The amount of oil that Iran can sell is not the only factor that affects the price. Markets tend to get jittery on the prospects of a conflict in the Middle East, thereby impacting the political risk premium. When Iran threatened to block the Strait of Hormuz, it was estimated that the oil prices represented a risk premium of $20 per barrel. However, there are chances that oil prices could fall in the days and weeks to come.

There will be some sort of peacemaking during at least the next six months, during which the US and the rest of the P5+1 group of nations will negotiate with what the White House refers to as a “long-term, comprehensive solution that addresses all of the international community’s concerns.”

Long-term implications

Considering the above-mentioned reasons, the current interim deal isn’t likely to shift the global oil markets all that much. However, the deal will have a far-reaching impact if Iran really agrees to scale back its nuclear program dramatically and the US and Europe ease back most existing sanctions.

On the other hand, Iran could add an additional one million bpd of oil in the world market, enough to offset all the expected growth in oil demand for 2014.

Given the complexity of the oil markets, the Organization of the Petroleum Exporting Countries (OPEC) could well scale back its own production in response to the growing Iranian oil sales. In order to fund the expansion and fuel growth of OPEC nations, it is beneficial for many of the oil producing nations to keep the oil prices high. OPEC nations also prefer to adjust capacity as per the demand, which is now stretched thanks to the high demand. On the other hand, the demand for oil could reduce if Iranian oil starts flooding the market, creating a glut.

This interim deal makes the chances of a long-term deal more likely, so traders will naturally price in marginally higher exports from Iran in the next six months or so. That could soften oil prices even more.

Iran has huge oil reserves, and with substantial global investments, it can produce more than three million bpd of oil. Some of the international oil and gas companies have invested a huge amount of funds in the Kurdish region of Iraq, finding ample amount of reserves that can be used for a longer period of time. Given sufficient investment in drilling and infrastructure, there are ample oil reserves in Iraq and Iran to add another five million bpd to global oil supplies within 10 years. In addition to those two, there remains roughly one million bpd of Libyan production offline due to continued unrest. Nigeria too has at least 250,000 bpd shut in. If these political and security problems are resolved today, the world oil supply would exceed the demand.

OILonomics for the US

The great renaissance in oil and gas for the US has coincided with sanctions on Iran and the unrest in the Middle East. In the long run, the easing of sanctions against Iran spells trouble for the economics of the tight oil plays that have sprung up across the US in recent years. Given the high drilling costs and steep decline rates, oil fields will only be financially viable if the oil prices increase or remain at the current level. If crude oil benchmarks were to fall to $75 a barrel and remain at that level for a couple months, it will spell trouble for drilling rigs across the country. The US onshore oil industry has been one of the brightest spots in America’s economic recovery. However, it could become a victim of its own politics.

A comprehensive deal seems very farfetched, given that there are plenty of reasons to be sceptical about the implementation of the current deal. Iran has to abide by the terms of the deal over the next six months. And the US has to sell the deal to key allies, which is not an easy task.

We still don’t know how much the current six-month deal will actually affect the global oil markets. The impact might be fairly limited for now, since there are plenty of speculations about the US-Iran agreement. In theory, it is believed that any sort of detente between the US and Iran should ease pressure on oil prices.

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