2013: Let The Oil Carnage Begin

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It won’t come as a shock to seasoned oil watchers that Goldman Sachs remains bullish on oil. Contrary to conventional opinion that international prices will fall to $80-90/b into 2013, the investment bank sees things differently. $130/b here we come in for a tumultuous 2013. In itself, that’s hardly newsworthy stuff, but what makes Goldman’s call far more interesting is that it’s entirely based around exacerbation of the Iranian question. As much as Iran currently appears to be under the cosh, the U.S. needs to have a very serious think about what it’s going to do with Tehran after November 2012 - not unless we’re supposed to live with a structural Iranian price premium over the next few years, all without any meaningful shift in Iran’s nuclear posture.

Understandable Drift

Policy drift on Iran is understandable as far as U.S. elections are concerned. Nobody wants to push the Iranian envelope too far now and risk upsetting American voters at domestic ballot boxes by causing an uptick on gasoline prices. But the problem is that the market has no idea where Washington really wants (or indeed realistically can) go with the Iranian question into 2013. Even seasoned oil hands such as Lord Browne (ex BP CEO), were struggling to come up with any convincing answers at a recent Chatham House event in the heart of London. Drift yes, but for how long, who knows?

What adds to the ‘drift narrative’ is the growing belief that sanctions are already working. Alas, that purely depends on what you think sanctions are for? Stopping the nuclear clock counting down in Iran, or putting pressure on the Iranian economy? If it’s the latter, then you’re onto a good thing. Iranian oil production has taken a significant hit, clipping overall output to a 23 year low of 2.63mb/d in September. More importantly, it’s halved exports to under 1mb/d. That’s had a major effect on the Iranian economy, reducing oil receipts to around $20bn in the last quarter, marking a 60% overall fall on last year’s figures. Foreign reserves have fallen to little more than $150bn, with repatriation of oil revenues becoming increasingly difficult without access to the U.S. financial sector. Iran is already accepting (delayed and heavily discounted) payments in Chinese yuan and Indian rupee; the riyal has dived 30% against the dollar in the past few weeks. Long gone are the days when Iran could paper over the cracks by using oil receipts to stabilise the exchange rate. Inflation is concurrently running above 30%, affecting anything from basic food stuffs to high end consumer goods. ‘Balance of payments crises’ might be putting things a bit too strongly, but these aren’t good times for Iran, any way you look at it.

The problem is as true as all that is, analysts are confusing ‘economic difficulty’ with ‘economic implosion’ in Iran. Outright collapse still remains an unlikely outcome (least of all from a falling riyal). Not only are the Iranians used to systemic economic mismanagement, the regime is still exporting sufficient oil to stay afloat in a $100/b price environment, and especially to Asian consumers.  That’s more than enough for Tehran to keep paying off key supporters of the regime across the military, bureaucracy and oil industry – a point that simply can’t be overlooked when assessing if sanctions are ever going to work in Iran. This isn’t about the ‘Tehran street’ but machinations in the ‘Iranian elite’. The idea that economic difficulty inexorably translates into political destabilisation is at best, circumstantial. Go one step further down that line and assume that it will prompt a shift in Iran’s nuclear posture, is even more farfetched. Enrichment isn’t seen as a party political issue to be trifled with, but as a vital national security interest designed to enhance Iran’s regional position and international leverage.

What that means for Western sanctions, is that if we’re to keep using economic levers to forge a political resolution of the nuclear question, then mere ‘economic difficulty’ is never going to be sufficient. The Iranian economy has to reach a ‘critical mass’ where Tehran accepts it has no viable option but to broker a negotiated settlement on enrichment or face total implosion. Right now we’re clearly not calibrating policy towards such ends – if anything Iranian oil exports are going to increase once new Asian contracts are signed and new legal loops found. This blunt reality directly underpins Goldman’s ‘pricing message’. Drift simply won’t do – not unless you want to live with the prospect of structurally higher oil prices without any discernible effect on Iran. Whoever wins the White House needs to get a grip on the nuclear question. What’s more, they need be brutally strategic in its logic and application to make any of this worthwhile. With that in mind, we’ve outlined two serious options linked to prevailing benchmarks that could play out over the next year (at the bottom and top end of the market). Both need to be considered, and both need to be tied to a crucial third diplomatic element to turn economic pressure into diplomatic outcomes. Are they all drastic? Yes. Will they be unpopular? Yes. But they might just help to shift the nuclear needle to avoid a far more drastic outcome that will inexorably play out otherwise; military strikes.

Scenario One: Iran Tighten Its Own Noose In A Low Price World

The first scenario assumes Goldman’s is overegging the Iranian omelette for now, and supply-demand fundamentals actually push prices towards $80/b or lower. That’s by no means beyond the realms of possibility given the supply overhang that's built up over the past few months, or indeed systemic demand side problems in China, Europe and the U.S. It’s not like America can’t go for QE4; China doesn’t want to flood the market with cheap money second time round. Europe remains structurally incapable of resolving the Eurozone crisis.

However, if we find ourselves entering a lower price environment, the U.S. has to resist its overwhelming temptation to do what it’s done every time prices have softened so far; use it as an opportunity to increase pressure on Iran. They did so in July by going after the financial and shipping sectors, and have just leant on the EU to increase pressures ahead of American elections. That makes for good short term headlines, but all it really does is (re)create its own self-fulfilling sanctions premium, enabling Iran to keep coining sufficient returns to offset price against volume. The economically smart move is to go the other way in a low price environment, quietly loosen sanctions and let Iran dump as much oil on the market as they can to find the real price floor - a move that would almost certainly depress prices  further. Rather than constraining Tehran to 1mb/d exports, it would be far easier to take the ‘Iranian premium’ out of the market at that stage, let them ratchet export figures up toward 1.5mb/d, sinking benchmark prices towards $60-70/b. The Iranians would be stupid enough to follow through on renewed exports to claim a short terms sanctions ‘victory’ over Washington, even if they they’d fall into a long term $60-70/b trap. For Iran, that would actually mean selling oil into its core Asian consumers at significantly lower benchmarks still.

And that’s the real prize to be won at the bottom of the market; let the Iranian’s tighten their own noose around their own necks. A $60-70/b outlook would rapidly bring Iran to the economic brink of collapse, a development that will be far more economically devastating than continually letting Tehran cash in on its own mark-up. Bottom line, making weak prices even slacker is one credible way of pushing Iran to the economic brink and towards the negotiating table.

Scenario Two: Push Prices Beyond Global Tolerance  

If that sketches a serious option at the bottom of the market, then the second scenario is to consider what play to make if Goldman’s has made a good call, and prices continue on an upwards trajectory. In part that might be based on Iranian meddling, in part because of supply difficulties afflicting producer states, not to mention the outside chance that economic output could pick up faster than expected on the demand side, and especially so in Asia. But perhaps more importantly than anything into 2013, oil bulls are well aware that the geopolitical calendar is stacked in their favour.  We have Israeli elections in January hyping Iranian attacks to whole new levels, followed by Presidential elections in Iran come June 2013. Both will weigh heavily on oil market sentiment, especially because the Strategic Petroleum Reserve becomes far less acute once U.S. elections are out the way next month. The threat of using the reserve has been one of the key reasons why Brent has kept below $120/b for traders wary of being burnt. Into 2013, the SPR ceiling no longer exists. The sky is the limit.

But rather than despairing about a high price environment, the U.S. should turn it into an advantage. The first move is outlining to Americans that there is no reason why gasoline prices should always cost less than $4 a gallon, especially when Washington is trying to pursue broader foreign policy goals in the Middle East. Get that straight, and the second, associated move, as prices rise above $120/b, is to make very clear that under no circumstance will the Strategic Reserve be used on a hard pressed Iran. That obviously requires getting the Saudis on-board to hold back on supplies to let prices shift towards $150/b - not with a view of testing how 'elastic' oil demand is - but with the single aim of getting Asian consumers on-board to join Iranian sanctions. If the Saudis (and IEA) refuse to quell a stampeding market by enhancing output, the security of supply and price implications will be more than enough to attract Chinese, Indian, South Korean and Japanese attention as the mainstay of Persian petroleum outlets. Beijing sources over half of its 5.5mb/d imports from Gulf States, the vast bulk of which comes from Arab states, compared to a fluctuating 500,000-750,000b/d Persian off-take. Washington’s road to Beijing to co-operate on sanctions therefore runs directly through Riyadh. If China’s core suppliers in the Gulf call time on Iranian nuclear ambitions, Beijing (and Delhi) would comply accordingly, either to exert serious diplomatic pressure on Iran to change course, or sever all oil ties. Iran would literally have no significant hydrocarbon outlets; its oil receipts would grind to an alarmingly abrupt halt. Tehran would have to book a seat at the negotiation table.

Default Position: Price Pressures Require Diplomatic Strategy

If that outlines two ‘bipolar’ scenarios for how sanctions might actually work - namely loosening them at the bottom of the market to deflate prices into Asian markets plunging Iran into deep economic chaos - or conversely choking off prospective Asian outlets in a very high price environment by forcing Eastern consumers to adhere to Gulf State interests, neither are any use without a diplomatic position in place to capitalise on the economic brinkmanship entailed. Getting Iran to the political table is one thing, persuading them to sign a nuclear deal is quite another.

For all the chatter around P5+1 diplomacy (Britain, France, Germany, Russia, America and China) the only two countries that actually matter here are the U.S. and China. The rest can frankly stay at home. Under any scenario you care to imagine, without Beijing on-board as the vital outlet for Iranian crude, little, if no progress will be made.

Obviously, one of the two scenarios outlined here could help to nudge China in that direction. But Beijing is also well aware that the costs of not going down the sanctions path are getting higher. The closer Iran inches towards its nuclear end game, the far more likely it becomes one of the players involved makes a rash move. If U.S. and Chinese interests align, the unfortunate acronym entailed reads ‘CACC’ - the 'Chinese American Co-operation Council' for the Middle East, but this can’t just be about a meeting of minds, but political sacrifices in Washington to give such a body credibility. The U.S. can’t just position sanctions to bring China into the fold; they need to give Beijing the joint lead in any subsequent negotiations. In no way can this be seen to be an international climb down for Iran; it has to be sold as a mutually beneficial deal. That would entail close controls and inspections over what Iran could do in the nuclear field, with the quid pro quo of enhancing Iran’s global energy stake and recognising its growing regional political stature. China basically cushions the Persian blow as a new, ‘inclusive’ form of international diplomacy.

Translate that into security terms, and Washington has to promote Beijing as credible provider, not consummate consumer of geopolitical stability if it wants energy supplies to consistently pan out. That looks a pretty forlorn hope right now given American ‘hard balancing’ of Chinese interests in Asia, both sides need to dump such folly and focus on external security vacuums growing at alarming pace in the Middle East. Failure to agree on a shared division of geopolitical (G2) labour in the Gulf could be very costly, particularly as the Saudi-Iran relationship sits at the heart of U.S.-Chinese relations as currently configured. Should the Iranian situation spiral out of control, the U.S. will act, irrespective of the fiscal damage that’s likely to inflict on the American economy. China would see this as last ditch power play by Washington to secure its place in the sand, albeit with the deep (very deep) irony that Beijing will ultimately be bank rolling such an effort through (in)direct financing of American printing presses.

Very Short On Political Time

With the stakes that high, time is horribly short to get the sanctions strategy right and diplomatic ducks lined up. The further both components continue to drift, the more likely we end up with explosive outcomes across the Iranian board. At this stage, it’s not Iranian politics that’s the concern, but that America only has one year (at most) to adopt the kind of serious sanctions strategy outlined here to forge a negotiated settlement. The sad fact is that America will probably fall prey to its own political cycle rather taking truly economically aggressive moves needed to force Iran’s hand. Unless rapid progress is made into 2013, there’s no way the White House will have the political space required to loosen Iranian sanctions in a low price environment, let alone driving markets towards $150/b to bring Asia on-board with American mid-terms slated for in 2014, followed by the two years of campaigning for Presidential elections in 2016.

‘Economic difficulty’ will be continue to be misread as pending ‘economic implosion’ in Iran, with 'middle of the road' sanctions doing little more than biding time for the growing clarion call for pre-emptive military strikes against Tehran as the default option to stop the nuclear clock towards 2015. Rest assured if that’s where we end up, the costs of war will far outstrip any of the collateral damage involved in piecing together a serious sanctions approach in 2013. Once American military hardware comes into play, the Iranian’s will block the Strait of Hormuz to derail the global economy, they’ll consider strikes on key Saudi production / refining facilities at Abqaiq and Ras Tanura. But far more importantly, they’ll ensure that the Middle East burns by stoking Shia tensions across the region. That applies to Bahrain, Syria, Lebanon and indeed Iraq and Saudi Arabia’s Eastern Province. Oil markets will suffer for years to come. Middle East frictions laid entirely bare.

So as controversial as the sanctions options presented here are for those who don’t want to take economic pressures to their logical conclusions, once we get beyond 2013, we’re merely drifting towards military actions against Tehran. The downside risks that presents are enormous. The Middle East will be scorched; the friction across international corridors of power, untold. It’s either that, or policy makers start considering that living with a nuclear Iran, although unpalatable, might be a better option than playing Russian roulette with the Middle East. Given its ‘Nobel Prize’ status, Europe will be first to float the idea, but depending on what answers that yields in Riyadh and Beijing, Washington and Tel Aviv would be wise to at least consider the response before taking things further. No good policy options are in play here, it’s merely a case of picking the least worse.

Whatever decisions are finally made, not only should all sanctions options be tried first to push Iran into a negotiation corner, but any military escalation needs to be discussed on an international basis having weighed up all the relative costs. If nothing else, Goldman’s would have good cause to be bullish on oil this time round. War, rather like international policy making, has an awkward habit of drifting and dragging on far beyond folks' initially limited imaginations, often to little (positive) effect.
