The U.S. decision to pull out of the Iran nuclear deal has potentially profound implications for the oil market. While withdrawal from the Joint Comprehensive Plan of Action (JCPOA) creates many known unknowns, any reduction in Iranian supply will likely exacerbate market deficits, suggesting upward pressure on pricing.
Given ongoing tightening of the oil market, we have pushed our near-term outlook to $80 per barrel (bbl) – materially above our long-term expectations for prices in mid-$60s. OPEC’s overall output is nearly 500,000 barrels per day (b/d) below quota due to the precipitous drop in Venezuelan output over the past six months and a lack of offsetting increases from other members of the cartel. Meanwhile, constraints in U.S. production growth over the next 18 months leave little opportunity for U.S. output to compensate for declines elsewhere.
We assume Iran’s oil exports will fall by 150,000 b/d in the second half of the year compared with the first half of the year. The amount potentially could rise to 300,000 b/d in 2019, assuming close but not full compliance with a 20% requested curtailment on a base of roughly 2 million b/d of exports. The net impact on the oil market could be greater if condensates and liquefied petroleum gas exports are also affected. Ultimately, however, OPEC’s response to the tightening of the oil market will be critical in determining just how constricted balances become and how high prices can trade.
President Trump’s 8 May announcement that the U.S. is abandoning the nuclear deal began a 90-day and 180-day staggered process of reimposing all sanctions previously waived under the seven-country accord, which was agreed in 2015. In addition to petroleum trade, the sanctions will include restrictions on transactions with the Iranian central bank and with shipping and insurance firms – actors critical to oil trading. For oil markets, the full reinstatement of sanctions without a clear path for negotiating a new or supplemental deal was the most bullish outcome.
Just how bullish, though, will only be answered once a series of known unknowns are clarified. Specifically, although sanctions on oil exports will be reenacted in 180 days, with expectations that trade partners will reduce volumes of imports ahead of time, the amount of oil taken off the market will be a function of a few key variables.
Supply and demand
For starters, there’s the extent to which Iran’s trade partners will need to reduce imports to receive a partial waiver from the U.S. on their remaining imports from Iran. This will only be clarified after consultations with U.S. trade partners.
In addition, Iran’s trade partners and other JCPOA signatories are unlikely to willingly reduce purchases and some will attempt to insulate their own companies and maintain trade links. This will likely reduce the impact of sanctions compared to 2012 – when, for example, Europe’s own sanctions immediately reduced the region’s imports to zero from 650 thousand b/d, rather than the 20% decrease every 180 days required to avoid U.S. sanctions. Ultimately, much will pivot on how aggressive the U.S. government is in applying extra-territorial sanctions.
The ultimate impact on balances will be a function of Russia and OPEC’s responses to rising prices and tightening balances. Pressure from allies on the cartel to increase supplies to compensate for any reductions in oil output from Iran will only increase as prices go higher, particularly as we believe this rise in prices will act as a drag on global growth (see previous blog post, “The U.S. Economy Isn’t Immune to Rising Oil Prices”). In fact, the latest global demand data already shows a deceleration in refined product demand, a trend we would expect to accelerate given recent price increases. Ultimately, we believe OPEC will respond with a cautious wait-and-see approach, which should support prices near term.
One last known unknown is whether the partial dissolution of the JCPOA will lead to increased regional instability. This could be salient to the oil market should regional confrontations, such as the recent missile attacks on Riyadh, Saudi Arabia, affect oil production.
All told, geopolitical uncertainty is aiding the tightening of oil balances, and creating uncertainty over future production capacity, which will likely support prices for the foreseeable future. To be sure, OPEC could act to cool prices and the U.S. could possibly release oil from the Strategic Petroleum Reserve if oil supply declines meaningfully. However, prices would likely have to rise substantially to motivate these responses.
For more of our views on oil and other commodities, see our 2018 Commodities Outlook.
Greg Sharenow is a PIMCO portfolio manager focusing on real assets.