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Lifting Sanctions on Iran a Mixed Bag

Our weekly commentaries provide Euro Pacific Capital's latest thinking on developments in the global marketplace. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.
By: 
John Browne
Monday, January 25, 2016
From a financial perspective, the New Year has been anything but happy. As of January 20th, the S&P had fallen over 9% since the beginning of the year, to levels not seen since 2014,reflecting a loss of some $2 trillion in market value. Compounding matters was the 30% collapse in oil prices, which brought crude down to the lowest levels in 13 years. The New Year has also seen further evidence of recession in the U.S., which has appeared in  a string of bad manufacturing service sector data.
 
Into this volatile mix comes news that the conclusion of nuclear talks with Iran and its release of Western hostages has led to a lifting of sanctions on Iran. These developments allow Iran, a country of nearly 80 million people, to reintegrate into the world economy after years of sanctions stemming from its nuclear program. This process will have a dramatic, but, as yet, undetermined impact on the already fractured Middle East and on the increasingly connected global economy.
 
The immediate effect will be that Iran’s imports and exports will rise. As far as exports are concerned, that only really means one thing: Oil. Iran’s oil exports are forecast to be able to add some 500,000 barrels a day, as Iran’s deputy oil minister has been quoted, to an oil market already threatened seriously by oversupply. This new supply comes at a time when central banks are already “struggling” to keep inflation up. More oil on the market means lower prices, which means lower inflation. This could impel central banks around the world to continue to shower the markets with monetary stimulus.
 
Measured against global production of 97 million barrels a day, as forecast by the IEA Oil Market Report, Iran’s five hundred thousand barrels per day seems trivial at just over one half of one percent. Also, it will take time for Iran to bring its full production on stream. It won’t be long before the Western energy companies jump into the market with both feet in order to bring Iran up to speed on all the new extraction techniques that the Iranians have missed as a result of sanctions. Just today, the Wall Street Journal announced that Schlumberger, the world’s largest oil field operator, was looking to re-acquire its Iranian subsidiary that it was forced to divest when the sanctions were first imposed.
 
However, as we know, prices for anything are set at the margin, and Iran’s added production will increase the current OPEC surplus production of 1.6 million barrels by an additional 30 percent, at the least. In addition, recessionary forces may drive oil consumption down even  further,  placing additional weight on prices.
 
Oil importing nations will benefit substantially from lower oil prices, as will consumers whose gasoline bills are plummeting. In some cases, U.S. gas prices are now well below $1 a gallon. According to the U.S. Energy Information Administration, Americans consumed a daily average of some 374 million gallons or 8.92 million barrels of gasoline in 2014. But this year’s fall in oil and gas prices has not yet been reflected in a rapid increase in consumer spending.
 
Lower oil prices could provide an economic shock to oil-producing nations in three important ways. First, national oil revenues would fall, forcing possible cuts in government spending. According to 2014 statistics from Alliance Bernstein, countries like Saudi Arabia, Iraq and Iran have the world’s lowest production costs of around $20 a barrel. They would suffer far less than Russia, the U.S. and Canada, with production costs of above $80 a barrel.
 
Second, and perhaps more importantly, is the effect of lower oil prices on corporate and national budgets, particularly those of oil producers that were formulated on estimates of far higher prices. Already, lower prices are hurting the high yield markets, causing concern of spreading contagion in debt markets. Oil prices that had been kept high for many years as a result of monetary stimulus sent false signals about future prices to the market and caused industry to make unneeded investments in production. Now that the bubble is bursting, the ensuing bankruptcies and write downs threaten a wider crisis.
 
Finally, the budgets of many oil producing nations were formulated on the basis of higher oil revenues. Saudi Arabia’s 2015 budget is believed to have been calculated on the basis of $98 oil and Russia’s on $100 oil. The Venezuelan economy, already reeling from years of a horrific socialist government, will face additional headaches. 
 
Dramatic shortfalls in these projected oil revenues may not be matched easily by cuts in government spending without causing political unrest. However, many of the major oil producing nations have accumulated vast wealth in so-called sovereign wealth funds (Sovereign Wealth Fund Institute), which are government owned. These have diversified into many non-oil-related assets, including equities, particularly in U.S. markets. If these funds are forced to execute substantial sales in order to finance government budget deficits, international asset prices, including equities, can suffer.
 
On the bright side, Iran can be expected to spend significant sums on imports from the major countries that agreed to the lifting of sanctions. There is no doubt that Iran’s young population is hungry for the Western goods that it has been denied for so many years. However, care should be exercised to ensure that Iran does not increase the financing of international terror or acquire dangerous military imports at the same time, particularly those technologies associated with the delivery and accurate targeting of nuclear missiles.
 
Although bringing Iran back into the family of nations may be a good idea in theory, for the reasons stated above, her return could not have come at a worse time. Another big question is what did the U.S. give away strategically in order to achieve this Pyrrhic victory? Sadly, only time will tell on that score. A wealthier Iran does not bode well for Saudi Arabia andprotectors of the Sunni-led status quo across the Muslim world.