Re-imposing sanctions on Iran: oil market implications

Re-imposing sanctions on Iran: oil market implications

On January 12, President Trump issued an ultimatum to European allies and Congress to “fix“ the Joint Comprehensive Plan of Action (JCPOA), also known as the Iran nuclear deal, or he will refuse to extend the sanctions waivers that permit the JCPOA to function. The possibility of a US withdrawal from the deal appears real. Since coming into office, the Trump administration has deliberately sowed the seeds of doubt on the JCPOA and the future of sanctions relief. Mr. Trump consistently renewed sanctions waivers very shortly before the respective deadlines and has uttered a countless number of public attacks against the agreement, calling it the “worst deal ever” and an “embarrassment to the US.” The waivers are up for renewal on May 12, and a failure to re-certify could remove hundreds of thousands of barrels of crude from the market, as a re-imposition of sanctions would initially target Iranian oil sales. Although an expiration of the waivers would probably not have the same effect as the 2012-2015 sanctions regime, it would cause a significant tightening of the supply-demand balance, and jeopardize investments made by energy firms after US sanctions were suspended.

Mr. Trump’s ultimatum: a sword of Damocles hanging over the JCPOA

Will Mr. Trump end the Iran nuclear deal? So far, the prospects do not look good. “I have outlined two possible paths forward: either fix the deal’s disastrous flaw, or the United States will withdraw,” Mr. Trump said in a statement in January, putting tremendous amount of pressure on European parties to the agreement (United Kingdom, France and Germany), which are largely unprepared for a US decision to walk away from the JCPOA. The president gave the trio 120 days to overhaul the deal, a near-impossible deadline considering the fact that European Union (EU) policy making operates on consensus, implying that any fresh sanctions on Iran would require the support of all 28 EU member governments. Iranian Foreign Minister Mohammad Javad Zarif responded that the deal was not renegotiable, and that Mr. Trump’s threats amount “to desperate attempts to undermine a solid multilateral agreement.”

The two other signatories, China and Russia, have also ruled out the possibility of a renegotiation. Russian Foreign Minister Sergei Lavrov said that Moscow would not support attempts by Washington to strengthen the deal, arguing that such a move would comprise negotiations over North Korea’s nuclear weapons program. A day after Mr. Trump’s ultimatum, China’s state news agency Xinhua reported that Foreign Minister Wang Yi had personally called Mr. Zarif to reassure him of Beijing’s commitment to the agreement. “China will continue playing a constructive role in maintaining and implementing the Iran nuclear deal,” Mr. Yi stated.

Therefore, chances that the president’s demands will be met are extremely slim, paving the way for a collapse of the JCPOA. The recent turnover in Mr. Trump’s administration also reinforces a potential US withdrawal from the deal. In place of H.R. McMaster, a three-star general and firm detractor of the Vietnam war, the president has appointed John Bolton as his new National Security Advisor, a hardline Republican and a foreign policy super hawk. Mr. Bolton served as undersecretary of state for arms control in George W. Bush’s administration and supported the 2003 invasion of Iraq. In 2008, he called for strikes against Iran as part of a strategy to cut off Tehran’s aid to insurgents in Iraq. While the 2015 agreement with Iran was being negotiated, he wrote a piece entitled “To Stop Iran’s Bomb, Bomb Iran,” which was published in the New York Times. Shortly after Mr. Trump’s ultimatum, he argued in the Wall Street Journal that “US policy should be to end the Islamic Republic before its 40th anniversary.” Similarly, the elevation of Mike Pompeo as secretary of state will not soften Mr. Trump’s stance on Iran. The hawkish director of the Central Intelligence Agency (CIA) is known for his notoriously tough views on Iran, calling the country a “thuggish police state” in a speech in October, and likening Tehran to the jihadist group Islamic State (IS).

In this context, it seems that renewed US sanctions against the Islamic Republic have never been so close, confronting international energy corporations and banks with ongoing operations in Iran to significant risks, and making mid to long-term planning extremely difficult.

The spectrum of renewed sanctions

If Mr. Trump was to unilaterally re-impose sanctions against Iran, he would use Section 1245 of the National Defense Authorization Act (NDAA) for the 2012 fiscal year, which, among other things, prohibits financial institutions from dealing with Iran’s central bank. Implemented under the Obama administration, the sanctions were aimed at slashing Iran’s oil revenues to pressure it to stop efforts to enrich uranium to levels that could be used in weapons. The law specifically targets the Iranian oil industry, as it allows the US president to exempt institutions of countries that have reduced their purchases of Iranian crude oil to a significant degree. What constitutes a “significant” reduction was left to the executive branch. Under the Obama presidency, reductions of 20 percent by volume of crude oil were considered to be sufficient, and importers had to demonstrate that they were making “significant” reductions every six months, as measured by volume and price.

The NDDA also enabled the president to lift the sanctions in the scenario where there would not be enough oil in the market to bridge the gap of an Iranian shortfall. Initially, the United States’ sanctions policy was limited to the banks of foreign oil companies, which constrained the administration in its ability to pressure Tehran. In order to extend the scope of its political leeway, president Obama signed in July 2012 Executive Order 13622, which opened up a wider field of application of the sanctions, targeting “any person” involved in the purchasing of Iranian oil.

At the time, the EU also imposed wide-ranging sanctions against the Islamic Republic through a 2012 measure banning the import of oil and petrochemical products as well as insurance on shipping, and freezing assets related to Iran’s central bank. The joint US-European sanctions had a severe toll on the Iranian economy: according to a study issued in April 2015 by the US Department of the Treasury, Iran’s economy was 15 to 20 percent smaller than it would have been had sanctions not been implemented. The sanctions cost Tehran $160 billion (£111 billion, €129 billion) in lost oil revenue alone, with Iranian exports falling by about 1 million barrels a day during the sanctions period, according to data from Thomson Reuters.

Were the waivers to expire in May, the Trump administration will have to set a date for when the sanctions will become effective again. Under the Obama administration, the implementation would start 180 days after the official announcement of the sanctions, a timeline which remains in the US Treasury Department as a guidance, even though it does not have any legal value. If the Trump administration decides to follow the same path as the previous administration, the sanctions would be effective from November 2018, with the first evaluation scheduled for May 2019. However, in the case where the Trump administration decides that the 180-day period provides oil companies a reasonable timeline to “significantly” reduce their purchases, then the first evaluation period would be in November 2018. In this scenario, international energy companies operating in Iran would have to come up immediately with a plan to reduce their oil purchases.

Potential impact on the oil market

Mr. Trump’s ultimatum comes at a time when the Iranian oil industry shows clear signs of recovery. Following the lifting of sanctions in January 2016, Iranian crude oil production quickly rose to a pre-sanctions level of 3.75 million bpd, which is in line with the OPEC quota. On average, in the past Iranian year (running from 21 March 2017 to 20 March 2018), Iran’s oil exports amounted to 2.55 million bpd, with the majority going to Asian and European markets. To attract foreign investors, Tehran introduced a new integrated petroleum contract (IPC), which offers energy companies more favorable terms than those under the former “buyback” contracts, as it allows firms up to a 49 percent share of output. France’s Total was the first Western oil major to take advantage of the new framework, with the signing of a $5 billion (£3.4 billion, €4 billion) agreement to develop Phase 11 of the South Pars gas field, in July 2017. In August 2017, Turkey’s Unit International, Russia’s state-owned Zarubezhneft, and Iran’s Ghadir Investment Holding also signed a $5 billion agreement to develop three oilfields, with estimated reserves of 10 billion barrels.

It is unlikely that the re-imposition of sanctions would have the same effect as during the most restrictive phase of US and international sanctions, from 2012 to 2015. States that complied with the Obama administration sanctions regime are signalling no willingness to cut back on their purchases of Iranian oil today. Countries such as China, who imported 474,000 bpd from Iran in February, might try to circumvent the sanctions by paying in non-dollar currencies, or by working through companies that have no US subsidiaries. It would also prove difficult to convince the EU to join the renewed US sanctions campaign. Brussels could even retaliate by enacting a “blocking regulation,” just like it did in November 1996, in response to two statutes passed by Congress, namely the Cuban Liberty and Democratic Solidary Act (1996), known as “Helms-Burton,” and the Iran and Libya Sanctions Act (ILSA, 1996). At the time, the EU had filed a complaint with the World Trade Organization (WTO), and passed a regulation that aimed at protecting the Union “against the effects of the extra-territorial application of legislation adopted by a third country.”

According to a recent study from Columbia University, if sanctions were to be re-imposed, we could expect an initial year reduction of approximately 400,000-500,000 bpd, which would represent a drop in Iranian oil exports from their present value of approximately 2.4 million bpd to 1.9 million bpd. Those results are based on the assumptions that EU oil and gas companies will decide separately whether to comply or not with renewed US sanctions; Russia and China will both oppose the sanctions and keep their current levels of purchase; certain US allies, including Japan and South Korea, will comply by fear of losing the American security umbrella vis-à-vis North Korea, and others, such as Turkey and India, will refuse to cooperate.

The removal of hundreds of thousands of barrels of crude from the market could cause a significant tightening of demand balance and send prices higher, especially in addition to the potential supply losses from Venezuela. If Mr. Trump does pull out of the deal, Brent crude could go up by $5 to 6$ per barrel, to an average $65 per barrel for the rest of 2018, according to forecasts by Citigroup, an investment bank. It is worth noting that Iran’s crude and condensate exports fell to a two-year low in March, due to a drop in demand from Asian markets, which might be anticipating a US decision to abandon the nuclear deal in May.

Market signals have been mixed. On the one hand, Mr. Trump’s decision to nominate Mr. Pompeo, which should have been bullish for oil prices, as it increases the probability that the nuclear deal will explode in May, barely registered on the spot price of Brent crude, whereas the six-month calendar spread continued to soften. On the other hand, the crude posted its biggest weekly gain since July when Mr. Trump appointed Mr. Bolton as his national security advisor, with prices going up to $65 a barrel for the first time since early February. Several trading houses, such as Glencore and Vitol, predict that a re-imposition of sanctions would have a limited impact, mainly because the world has much larger crude oil stocks than it did in 2012. In theory, these views are justified, as any loss of crude from Iran could be offset by increased production and exports from Saudi Arabia, Kuwait, the United Arab Emirates, Iraq and Russia.

In the end, European energy corporations will be the first to be affected by a decision to rescind the waivers, as reflected by Total’s CEO Patrick Pouyanné’s comments at the 2018 World Economic Forum in Davos; he noted that a US withdrawal from the deal would force Total to “re-evaluate” its engagement in Iran. The vast majority of Western oil companies rely heavily on their access to the US market to fund their operations, which involve a wide range of American products (components, software etc.). For oil majors such as Total, the collapse of the JCPOA would mean walking away from investments worth at least a billion dollar, especially in the scenario where the Trump administration conducts the first evaluation period in November 2018. Those companies will be waiting anxiously for May 12.

About Author

Leo Kabouche

Leo is a Toronto-based analyst who has worked for several consulting firms in Canada & Europe. His areas of expertise include the intersection of energy and geopolitics in oil and gas markets, in climate policy as well as in national security. His research also delves into the relationship between political risk and extraterritorial regulations tackling corruption and money-laundering practices on the international stage. He holds a MSc in International Affairs from the University of Montreal.