Previously we heard Pimco's thoughts on the matter of an Iranian escalation with "Pimco's 4 "Iran Invasion" Oil Price Scenarios: From $140 To "Doomsday"", now it is the turn of SocGen's Michael Wittner to take a more nuanced approach adapting to the times, with an analysis of what happens under two scenarios - 1) a full blown EU embargo (which contrary to what some may think is coming far sooner than generally expected), and the logical aftermath: 2) a complete closure of the Straits. The forecast is as follows: 1) "Scenario 1: EU enacts a full ban on 0.6 Mb/d of imports of Iranian crude. In this scenario, we would expect Brent crude prices to surge into the $125-150 range." 2) "Scenario 2: Iran shuts down the Straits of Hormuz, disrupting 15 Mb/d of crude flows. In this scenario, we would expect Brent prices to spike into the $150-200 range for a limited time period." The consequences of even just scenario 1 is rather dramatic: while the adverse impact on the US economy will be substantial, it would be the debt-funded wealth transfer out of Europe into Saudi Arabia that would be the most notable aftermath. And if there is one thing an already austere Europe will be crippled by, is the price of a gallon of gas entering the double digits. And then there are the considerations of who benefits from an Iranian supply deterioration: because Europe's loss is someone else's gain. And with 1.5 million of the 2.4 Mb/d in output already going to Asia (China, India, Japan and South Korea) it is pretty clear that China will be more than glad to take away all the production that Europe decides it does not need (which would amount to just 0.8 Mb/d anyway).
SocGen's situation summary:
- Scenario 1: EU enacts a full ban on 0.6 Mb/d of imports of Iranian crude.
- In this scenario, we would expect Brent crude prices to surge into the $125-150 range.
- The extent of the bullish impact will depend on the terms of the actual EU embargo, including how quickly it will be phased in. Another important variable will be how much Iranian crude is cut by non-EU countries, such as Japan and S. Korea, as a result of US pressure. This will determine how much Iranian crude has to be replaced by Saudi Arabia, and how much spare capacity Saudi Arabia has remaining after it increases output. Lower Saudi spare capacity equals higher prices. An EU embargo would possibly prompt an IEA strategic release. The price surge would dampen economic and oil demand growth.
- An EU embargo is considered likely, especially after the EU reached an agreement in principle on an embargo on 4 January. When it is announced, depending on the timing and details, we may revise our base case oil price forecast upward. Our current Brent crude price forecast for 2012 is $110.
- Scenario 2: Iran shuts down the Straits of Hormuz, disrupting 15 Mb/d of crude flows.
- In this scenario, we would expect Brent prices to spike into the $150-200 range for a limited time period.
- We believe it would be relatively easy for Iran to shut down the Straits of Hormuz. A credible threat from missiles, mines, or fast attack boats is all it would take for tanker insurers to stop coverage, which would halt tanker traffic. However, we believe that Iran would not be able to keep the Straits shut for longer than two weeks, due to a US-led military response. The disruption would definitely result in an IEA strategic release. The severe price spike would sharply hurt economic and oil demand growth, and from that standpoint, be self-correcting.
- A Straits of Hormuz shutdown is not likely. We estimate the probability of this very high impact event at 5%. Although Iran may like the idea of retaliation in order to hurt its enemies, by halting its oil export revenues, it would hurt itself even more. Moreover, Iran would do this at the cost of provoking a military response that could destroy much of its military and perhaps even its nuclear program.
A quick summary of who are the main export partners of Iran crude:
Since early November, geopolitical risk related to Iran has re-emerged as one of the factors supporting prices in the oil complex. More to the point, the markets have become concerned about the possibility of a partial disruption to Iran’s 2.4 Mb/d of medium and heavy sour crude exports (as detailed in the table below). In addition, the markets are also thinking about the small probability but very high impact scenario where Iran shuts down the Straits of Hormuz, which would halt flows of 15 Mb/d of crude and a significant amount of NGLs, refined products and LNG.
The key developments since November have been an important IAEA report on Iran’s nuclear program, moves by the US and EU to impose sanctions on the Central Bank of Iran and on the oil sector, and Iranian military exercises in the Persian Gulf.
- The escalation of the issue for the oil markets began ahead of the widely anticipated November 8 International Atomic Energy Agency report on Iran. This report contained much more evidence than previously published which strongly indicated the military nature of Iran’s nuclear program (although the report stopped short of formally reaching that conclusion - a step with diplomatic repercussions). Before and after the IAEA report, there was much discussion about an Israeli and/or American military response to Iran’s nuclear program.
- In early December, the EU began to consider a ban on imports of Iranian crude (more on this below).
- In late December, Iran conducted ten days of naval and military exercises in the Persian Gulf and the Straits of Hormuz. Iran repeated its oft-stated threats to close the Straits of Hormuz. Both Iranian and Western naval forces have conducted exercises in the PG many times before: Iran practices closing down the Straits of Hormuz and the Western allies practice reopening it. However, it seems more serious this time because of the context: Iran’s steady progress towards a nuclear weapon capability and – in response – moves to increasingly tough sanctions by the US and EU, which are clearly targeting oil.
- On December 31, President Obama signed new US sanctions into law. The sanctions say that any financial institution that does business with the Central Bank of Iran cannot do business with the US financial system. Because the Central Bank receives payments for almost all of Iran’s crude export sales, this directly targets Iran’s oil sector and revenues, which accounts for 60% of its economy. In effect, the oil companies and refineries that purchase Iranian crude would be forced to stop buying, because they would have no way to pay for the oil. Despite these harsh restrictions, the law does not take effect for 6 months (although Iran’s currency has already plummeted, losing 40% of its value vs. the dollar in the last month). Even more importantly, the White House has almost total flexibility and discretion in how to enforce the law. The US wants to hurt Iran, but with a fragile economy, it does not want to cause a shortage of crude and an oil price spike. The US has said that it will grant waivers to countries that show progress in reducing their purchases of Iranian crude oil. The bottom line is that the US now has a very powerful tool to exert pressure on Iran’s crude customers, but it will use this tool with finesse and an eye on the oil markets.
- On January 4, the EU reached an agreement in principle to ban its 0.6 Mb/d of imports of Iranian crude – 25% of Iran’s total exports. Italy, Spain, and Greece are the European countries most dependent on Iranian crude, and apparently, the objections of these countries have been overcome. It is not at all clear what the EU embargo will look like. As Italy has made very clear, it has not even been decided whether the embargo will be full or partial, and how quickly it will be implemented or phased in. The key is that EU countries need to be able to arrange alternative supplies, primarily from Saudi Arabia, the main holder of spare production capacity. Talks on making these arrangements are assumed to have been taking place since December, if not earlier. The EU is reportedly hoping and planning to announce its embargo, including the details, on January 30, at the next EU foreign ministers meeting. Europe has the same concerns about a fragile economy and an oil price spike as the US, probably even more so. Because of this, we expect a slow and gradual implementation of what will eventually become a full embargo. One possible option that has been reported is for the EU embargo to take effect at the end of June, at the same time as the new US sanctions. This would be a tidy solution and makes a lot of sense. Whenever the EU embargo is officially announced, we expect the IEA to quickly follow up and make it very clear, probably through a press release and/or a press conference, that it would coordinate a release of strategic reserves, if needed, to ensure crude supplies to its European member countries. We also expect Saudi Arabia to make it known, perhaps quietly, that it will be providing additional supplies to European refiners.
While so far Iran talk has not manifested in big price swings in Brent, Urals have been notably impacted:
Despite all of the talk about Iran, there has been no discernible impact on Brent prices, in absolute terms. Front-month ICE Brent prices remain rangebound. At $112-114 in recent days, Brent has risen to the top of the trading range seen since November; however, there has been no upside breakout. Moreover, recent crude price gains have been not only due to Iran, but also to positive macro data flow from the US and China, and to strong risk appetite. That said, we believe that the US sanctions and the EU embargo are clearly supportive. Iran represents a bullish tail risk that will make traders think twice about going short.
The one place where EU embargo concerns may have had a market impact – though it is debatable – is on Urals prices, where differentials to Brent have been quite strong. Urals, which directly competes with Iranian grades and is a substitute, has priced at an unusual premium to Brent in recent weeks. However, the Urals strength preceded the proposed embargo, and Iran is only one of several factors. Urals has been supported by strong Russian domestic demand and restrained exports to Europe, as well as ongoing supply disruptions in Syria (-160 kb/d) and Yemen (-80 kb/d).
How much oil is at stake.
What’s at stake? Iran produces 3.5 Mb/d of crude. It processes 1.1 Mb/d of crude in domestic refineries, and exports the remaining 2.4 Mb/d. The oil markets are concerned with the 2.4 Mb/d of exports. The breakdown is shown in the table above. Of the 2.4 Mb/d of crude exports, 0.8 Mb/d goes to OECD Europe, including 0.6 Mb/d to EU countries and 0.2 Mb/d to Turkey. Iran’s main market, however, is Asia, which takes 1.5 Mb/d of crude exports, including 0.5 Mb/d to China, 0.4 Mb/d to India, and 0.5 Mb/d to Japan and S. Korea.
As discussed above, our view is that the EU will put a full embargo in place, which would stop the 0.6 Mb/d to the EU; however, after the announcement, the implementation will be phased in gradually. We do not believe that Japan and S. Korea will participate in any embargo; however, the US, through its own sanctions, will put pressure on its close allies to reduce imports from Iran, and the combined 0.5 Mb/d could be lowered. We expect flows to China and India to continue; they may even increase, particularly if refiners can negotiate discounts from Iran. However, as discussed below, we do not think that Iran will be able to simply sell its entire EU 0.6 Mb/d in Asia instead.
A breakdown of how SocGen gets to its Scenario targets: "Scenario 1: EU bans imports of Iranian crude. Brent prices in the $125 - $150 range."
When the EU embargo is announced and is implemented, obviously there will be a bullish knee-jerk reaction across the crude complex, paper and physical, in response to the announcement. Beyond this, what will happen?
As noted above, we believe that Iranian flows to Europe will be replaced, primarily by Saudi Arabia, but with some help from Kuwait, the UAE, and Qatar. Discussions to arrange those replacement supplies are reportedly already taking place. As shown in the chart below, OPEC crude production spare capacity in November was 2.25 - 2.75 Mb/d; indications are that it did not change materially in December. With Saudi output at 9.75 Mb/d according to the IEA, and capacity at 11.5 – 12.0 Mb/d, Saudi spare capacity was 1.75 Mb/d – 2.25 Mb/d. Kuwait, the UAE, and Qatar combined for another 0.5 Mb/d of spare capacity, mainly in Kuwait and the UAE. The Saudis alone can easily replace the EU’s 0.6 Mb/d, and there is more than enough spare capacity to make up for volumes that other countries, such as Japan and S. Korea, might need if they reduce imports from Iran.
However, even though the Saudis and OPEC can make up the supplies, an embargo would be bullish. The reason is that there would be less spare capacity remaining after replacing Iranian volumes. Libya is also a wildcard. If Libyan production continues to ramp up from the current 0.9 – 1.0 Mb/d, we expect the Saudis to start to decrease their Libyan replacement volumes, which would give them back some spare capacity.
There are other variables. In order to make up for lost sales to Europe, we would expect Iran to try to sell additional volumes to Asia, specifically to China and India. This is easier said than done. Focusing on the Saudis, refiners in both countries have term contracts with Saudi Aramco, and could not simply tell the Saudis to reduce their exports. They would have to ask, and the Saudis have no reason to say yes. Why should they lower revenues in their key regional market, in order to help out their biggest geopolitical rival? It would not make any sense.
The question, therefore, is: how much incremental Iranian crude could China and India take? It depends on their overall crude demand level, how much they are committed to taking from other producers, and importantly, what the price of Iranian crude is. Chinese and Indian refiners would have good negotiating leverage with Iran, who would have to cut their prices for Asian customers. Indeed, China has already taken significantly less Iranian crude in January, they may do it again in February, and we believe this to be posturing and setting up a negotiating position. Our “guesstimate” is that Iran would only be able to sell a maximum of 200-300 kb/d of the available EU 600 kb/d to China, India, and maybe other countries. So Iran would get hurt from lower revenues, due to both lower volumes and also due to forced price discounting.
Logically, an embargo on Iran should mainly impact the sour crude markets, in the form of stronger backwardation on the forward curve for Dubai, stronger differentials vs. sweet crudes, and stronger differentials for Asian vs. Atlantic Basin crudes. However, we believe that paper markets would also be affected and that there would be a bullish impact on ICE Brent and NYMEX WTI, even though they are sweet crudes.
Depending on the EU embargo scenario and how much Iranian crude is cut by non-EU countries such as Japan and S. Korea, and depending on how much Saudi spare capacity remains after replacing Iran volumes, we expect Brent prices in the $125-150 range. An embargo would possibly prompt an IEA strategic release. Finally, the price spike would dampen economic and oil demand growth. An EU embargo is likely, and when it is announced, depending on the details, we may revise our base case oil price forecast upward. Our current Brent crude price forecast for 2012 is $110.
And " Scenario 2: Iran shuts down the Straits of Hormuz. Brent prices in the $150 - $200 range."
The most bullish scenario would be if Iran retaliates, or even pre-empts, an embargo by trying to follow through on its oft-stated threat to shut down all shipments through the Straits of Hormuz. Based on JODI crude exports data for Iran, Iraq, Kuwait, Saudi Arabia, the UAE, and Qatar, we estimate flows are currently running at around 15 Mb/d. This is based on total exports from those countries of roughly 16 Mb/d, minus around 1 Mb/d of flows that do not go through the Straits of Hormuz; the latter includes 450 kb/d of Iraqi exports through the Kirkuk – Ceyhan northern pipeline and 800-900 kb/d of Saudi exports through the East-West pipeline to Yanbu on the Red Sea.
We believe it would be relatively easy for Iran to shut down the Straits of Hormuz, but that they would not be able to keep it shut for long. Importantly, Iran would not actually need to succeed in sinking an oil tanker or a naval ship to shut down the Straits. A credible threat would be enough to shut down oil shipments, because tanker insurers would stop coverage and traffic would cease. Threats could include mining the Straits; launching a surface-to-ship missile or maybe even just arming launch radars on those installations; or swarming armed small fast patrol boats around tankers – all of which would be detected by routine naval and air patrols conducted by the Western allies.
That said, we do not believe the Western allies would allow the Straits to be shut for a prolonged period. A disruption to oil flows would be considered a national and economic security threat, and if necessary, military force would be used to re-open the shipping lanes in the Persian Gulf. Our view is that Iran would not be able to keep the Straits closed for more than 2 weeks. In addition, after the re-opening, it would be possible to maintain security through the use of naval escorts for tankers, as happened during the 1980s Iran-Iraq war.
In the event of a shutdown of the Straits of Hormuz, disrupting 15 Mb/d of crude flows, we would expect Brent prices to spike into the $150-200 range for a limited time period. The disruption would definitely result in an IEA strategic release. Lastly, the severe price spike would sharply hurt economic and oil demand growth, and from that standpoint, be selfcorrecting. A Straits of Hormuz shutdown is not likely; we estimate the probability of this very high impact event at 5%. Although Iran may like the idea of retaliation and hurting its perceived enemies, it would hurt itself even more, by halting its oil export revenues. Moreover, Iran would do this at the cost of provoking a military response that would destroy much of its military and perhaps even target its nuclear program.
Next steps and key dates:
- December 31/January 1 – The US responsibility for securing Iraqi airspace formally ended, and Iraq’s responsibility for its own airspace formally began. Iraq has no effective air force. Therefore, the shortest route for Israeli aircraft to attack Iran’s nuclear sites - straight through
Iraq – is available. - January 30 - EU foreign ministers meeting: possible announcement of EU embargo on imports of crude from Iran
- February – Iran’s next announced naval exercises in the Persian Gulf March – Iranian elections
- June 30 – new US sanctions on the Central Bank of Iran take effect.
- September – According to Ehud Barak, the Israeli Defense Minister, after September, a successful military attack on Iran’s nuclear sites will no longer be possible, because Iran will widen the redundancy of its facilities and spread them out over more sites, including the impenetrable site at Fordow (near Qom), which is located inside a mountain.
- November – US elections
- December – According to Leon Panetta, US Secretary of Defense (and former Director of the CIA), Iran could have a nuclear weapon capability by the end of 2012.
