NOV
19

Low oil prices: Help or hindrance for the P5+1 and Iran?

 

Next Monday, November 24, is the deadline for negotiations between Iran and the P5+1 (the United States, United Kingdom, Russia, China, and France + Germany) regarding Iran’s nuclear program. The recent plunge in oil prices has battered Iran’s economy, and ample supplies have further reducing the global economy’s reliance on Iranian crude oil and products. In this context, it’s worth examining how current prices impact the negotiations, for both Iran and the West. First, let’s look at Iran. Lower oil prices impact their incentive structure in one of two possible ways. Since the country has been earning less on every barrel of oil it exports, some speculate that Iran has become significantly more willing to cooperate with the P5+1. Under this assumption, the country must pursue the highest possible volume of oil exports as soon as possible, compensating for lack of revenue per barrel by exporting more. Under this strategy, not only will Iran will be more conciliatory with the P5+1, but will also offer highly favorable business terms to international oil companies interested in producing its reserves in order to offset the political risks. These risks include failure of Iran to fully cooperate with the terms of the deal and a return of heavy sanctions, as well as the historically unfavorable terms Iran has provided to international oil companies. Earlier this year, it was widely reported that Iran, already anticipating an imminent lift of sanctions, was considering offering production-sharing contracts to international investors for the first time—a contract type preferred by the industry as it provides higher potential profits at lower risk. Such behavior suggests that Iran has been banking on a return of foreign investment into its oil sector and higher export volumes for months. However, although Iran’s production costs are estimated to be quite low—an appealing condition for oil companies in a low-price era—there has no doubt been damage to some of the country’s oil fields and infrastructure, which has lacked new investment and technologies for some time. Foreign operators would likely seek to go slow in any approach to Iran’s energy sector. Simultaneously, lower oil prices could also undermine Iran’s interests in forging a deal—the return of their exports will only add to the market’s already ample supply. This further deflates prices, and creates incentive for Iran, as well as other oil-exporting countries, to continue increasing exports to compensate for the shortfall. Under these conditions, the relative value to Iran on the lifting of sanctions specifically targeting oil exports is lower, and some of the additional benefit of increased volume will be offset by the consequent decrease in the global prices. Meanwhile, the country’s interests in developing a nuclear weapon remain unchanged. This could complicate matters for the West. Right now, it’s no secret that a huge gulf remains between the two parties, with Iran refusing to eliminate most of its existing stockpile of enriched uranium and centrifuges, while Washington refuses to proceed with a deal without significant concessions. If lower oil prices drive the value of exports below Iran’s perceived value of obtaining a nuclear weapon, the P5+1 faces a considerable challenges. These calculations on Iran’s part change substantively depending on their perception of how long oil prices will stay low, and how low they are likely to drop. If Iran perceives a long-term likelihood (about 4-7 years) of low oil prices (below $75 per barrel—$30-40 below its budget breakeven), the P5+1 has lost its most powerful negotiating tool—the full removal of sanctions on oil exports. Additionally, as we have noted in previous analysis, economic sanctions have already partially impaired the relationship between oil prices and Iran’s macroeconomic outlook. However, it’s also possible that the fact that Iran has already been forced to make significant fiscal and monetary adjustments to cope with lower energy revenues could give it some resilience to a downside oil prices shock, particularly in the short-term. In either case, we can assume the following:
  •       Iran will be more aggressive towards relief of sanctions that do not target its energy sector, in order to revitalize other parts of its economy. Iran has been undergoing structural reforms to make its investment climate more business-friendly, and aims to develop greater economic diversity away from pure reliance on oil export revenue.
  •       Estimates from Roubini Global Economics suggest that the return to the implementation of sanctions present before the Joint Plan of Action (JPOA) would mostly erase the economic growth Iran has experienced in the last 12 months (with an estimated economic expansion of 2.5% y-o-y versus sharply negative growth in 2012/13).
  •      New sanctions such as those pending in congress would likely lead to a recession, as Iran’s oil output falls and the government has to make fiscal cuts to balance the budget. Thus, Iran has greater incentive to avoid total collapse of negotiations and reinstatement of tighter sanctions on its energy sector, to avoid exacerbating current shortfalls in oil revenue
  • Lower oil prices also create divergent tactics for the P5+1. Historically, concern over a global spike in oil prices has been a major factor inhibiting sanctions that would fully remove Iran’s oil exports from the market. With this concern all but completely alleviated, the West, and particularly the United States, is truly in a position to take an aggressive stance towards negotiations.
Similarly, ample oil supplies reduce the incentive for China and other countries to cheat and make side deals to purchase Iran’s oil. In the past, China continued importing Iranian crude per day, but their demand for Iranian’s supplies has softened in H2 2014. If Iran is willing to discount its oil as it becomes desperate to make sales, some of the Asian trading partners might be willing to break ranks, but Iran has been reluctant to take this approach in recent months. However, some geopolitical considerations undermine the strength that low oil prices provide the P5+1. As we noted in a previous report (July 2014) the coalition might be less unified than in 2012 given the varied interests of the members. In particular, the deterioration of U.S. ties with Russia could increase the likelihood that Russia would strike a side deal with Iran, buying some of its oil, to keep that oil off the global market while supplying Iran with goods. We don’t know exactly how the current oil market conditions will impact the negotiations, but much evidence seems to point towards the fact that it increases Iran’s need to lift sanctions while strengthening the position of the P5+1. If there is no resolution and another extension is needed (which is likely), the question becomes not when but if these two parties will ever find a middle ground.