Macro Battleship with Christopher Wood

There is one area which is receiving very little attention in the markets but which could well be dominating headlines and driving market movements in coming weeks and months. That is the countdown to the Sept. 5 deadline set by Iran in terms of Tehran’s threat to walk out of the 2015 nuclear deal, known as the Joint Comprehensive Plan of Action (JCPOA), unless Europe and other signatories to the 2015 nuclear agreement persuade America to pull back on its sanctions targeting the Islamic Republic.

 

Some History on the JCPOA

Remember America unilaterally exited the nuclear deal on May 8, 2018 and re-imposed sanctions on Iran on Nov. 5. After giving a 60-day deadline in early May to the remaining signatories to the nuclear deal to protect Iran from U.S. sanctions, Iran announced in early July that it would start enriching uranium above a concentration of 3.67% within a few hours.

This was the limit below which Iran had to stay under the terms of the 2015 agreement. It also gave the other signatories a final 60 days to find ways to counter U.S. sanctions or it would further breach the nuclear deal. For the record, Iran has recently acknowledged that its stockpile of low-enriched uranium has exceeded the 300 kg limit allowed under the deal.

 

A Possibility of War in the Middle East

Such moves by Tehran would immediately raise the issue of how Israel will respond. I had some conversations with people based in the Middle East of late and was surprised, if not a little shocked, to hear the extent to which there is genuine concern in the Gulf about a regional conflict breaking out in coming months triggered by the fallout from the Iran deadline. If Israel is potentially prepared to strike Iran over a renewed escalation in its nuclear activity, the word is also that Iran could be prepared to strike Saudi Arabia and United Arab Emirates oil production facilities in retaliation.

Clearly, the two main regional drivers of the proxy conflict against Iran in recent years, much of which played out in the civil war in Yemen, have been Saudi Arabia and Abu Dhabi – just as they were the main instigators of the now 26-month long blockade of Qatar.

 

The Politics of Personal Alliances

Still, of late there is talk that the alliance between the 58-year-old Mohammed bin Zayed (MBZ), Crown Prince of the Emirate of Abu Dhabi, and the 33-year-old Mohammed bin Salman (MBS), Crown Prince of Saudi, has been fraying. Abu Dhabi has pulled back its troops from the Yemen conflict (see New York Times article: “UAE pulls most forces from Yemen in blow to Saudi war effort”, July 11, 2019 [paywall]), while there have been reports of official visits by the UAE government to Iran in late July for the first time in six years (see, for example, Washington Post article: “UAE and Iran hold rare talks in Tehran on maritime security”, July 2019). All this suggests perhaps second thoughts on the part of Abu Dhabi about the wisdom of baiting Iran while Saudi remains bogged down in Yemen in what increasingly looks to be the equivalent for Saudi of America’s experience in Vietnam or Russia’s in Afghanistan.

Meanwhile, the question is whether Abu Dhabi’s attempted rapprochement with Tehran has come too late. For the word among the informed is that the main promoter of the surprise succession of MBS to the role of Crown Prince and heir apparent over the previous candidate Prince Muhammad bin Nayef, and the resulting much more overtly anti-Iran foreign policy, was MBZ. Remember Nayef was appointed Crown Prince in April 2015 and was replaced by MBS in June 2017.

Now, Middle East politics is fiendishly complicated and highly personal. It might be asked what all this has to do with financial markets. The answer is a lot since a real war in the Middle East, as opposed to yet another proxy affair, will have dramatic market consequences.

 

How a Conflict Could Affect the Price of Oil

The key market-driven symptom of such a conflict would, likely, be an exploding oil price. On this point, the near-term point of focus is on how much oil Iran is currently able to sell in the face of the U.S. sanctions. There is no concrete answer to this question as it has become the equivalent of a state secret for Iran as it strives to get around the sanctions.

A recommended article in the New York Times last month (“Sanctions turn Iran’s oil industry into a spy thriller”, Aug. 10 2019) described how the business of selling Iranian oil has been turned into a “high-stakes global game of espionage and counterespionage”. Thus, Iran said last month it had arrested 17 Iranians it claimed were working for the CIA in oil espionage.

Brent Crude Oil Price

Brent Crude oil price - Sep 2019

Source: Bloomberg

Market guesstimates are that Iran’s foreign oil sales have declined from 2.5m barrels per day before the first set of sanctions were implemented in 2018 to around 500,000 barrels per day currently.

If the stated goal of Washington is to bring Iran’s oil exports to zero, market guesstimates are that Iran’s foreign oil sales have declined from 2.5m barrels per day before the first set of sanctions were implemented in 2018 to around 500,000 barrels per day currently. The same article noted that, to encourage buyers, Iran sells oil about US$4 barrel under the market price.

So, in a curious way, the short-term impact of the sanctions could be to reduce the price of oil, which is currently down 30% from the peak of US$86.7/barrel reached before Donald Trump did his U-turn last November by announcing waivers on eight countries buying Iranian oil, including China and India (see previous chart). But those waivers are no longer in place.

Iran Total Crude Oil Exports and Exports to China

Iran total crude oil exports and exports to China

Source: Bloomberg (Estimates based on tanker-tracking data)

The main buyer of Iranian oil reportedly remains China, just as it was the main buyer prior to the imposition of sanctions. China accounted for 34% of Iranian crude oil exports in 2018 and 50% in the first seven months of 2019, according to Bloomberg estimates based on its tanker-tracking data (see previous chart).

A Reuters article last month also quoted an estimate by three research firms that track tanker movements that between 4.4m and 11m barrels of Iranian oil were discharged into China in July or 142,000 to 360,000 barrels per day (see Reuters article: “China continued Iran oil imports in July in teeth of US sanctions”, Aug. 8 2019). The upper estimate would imply that imports were up to half the level of a year earlier. According to official data from China’s General Administration of Customs, China crude oil imports from Iran were 786,000 barrels/day in July 2018 and 221,000 barrels/day in July 2019, the latest data available (see following chart).

China Crude Oil Imports from Iran

China crude oil imports from Iran

Note: Converted from official data in metric tonnes. Source: China General Administration of Customs

Meanwhile, an interesting article published in July by Bloomberg shed some light on how China is currently purchasing Iranian oil (see Bloomberg article: “Millions of barrels of Iranian oil are piled up in China’s ports”, July 22, 2019). It described how tankers have been offloading millions of barrels of Iranian oil into storage tanks at Chinese ports. The bulk of Iranian oil in China’s bonded tanks is still owned technically by Tehran and is therefore considered not in breach of sanctions since it has not gone through Chinese customs and so is deemed still to be in transit.

The same article noted that, so far, the U.S. has not opined whether it views such a manoeuvre as a breach of sanctions. Meanwhile, from an oil price perspective, the stored oil has the potential to push down oil prices in the short term if Chinese refiners decide to draw on it. It also allows Iran to keep pumping and move oil near to potential buyers.

If this is the short-term risk to the oil price, the reason to go long oil is the potential political catalyst described earlier in terms of Tehran following through on its threat to walk out of the 2015 nuclear deal and resume nuclear enrichment to much higher levels.