Iran Deal Skeptics Could Trigger Era of High Risk Premium for Oil
Last week’s announcement of the framework of a deal between Iran and the P5+1 group of nations sparked mixed reactions in the United States, in Iran, and in U.S. allies in the Middle East, but all agreed on the momentous nature of the occasion. Hailed by President Barack Obama as a “historic understanding” that, if implemented, will prevent Iran from obtaining nuclear weapons, and derided as “a grave danger to the region” by Israeli Prime Minister Binyamin Netanyahu, the framework agreement has quickly proven to be many things to many different people. It is this wide range of interpretations that makes it clear that a calmer, more secure Middle East—while a central goal of the negotiations—is far from an automatic outcome in the wake of the framework deal. In turn, while a final deal would return much of Iran’s lost oil exports to the global market, the overall effect may not be beneficial to oil consumers.First, as observers have been quick to point out, differing reports from Iran and the U.S. in the wake of the negotiations show that there are many details yet to be confirmed before a final deal can be signed—details potentially including such critical issues as Iran’s stockpile of enriched uranium, inspections of military facilities, and the timing and dynamics of sanctions removal. If the remaining details can be decided along the lines of what was reported yesterday, however, many see this as a more extensive set of restrictions than had been anticipated earlier this week. In fact, despite widespread reports of celebrations in Tehran by jubilant Iranians, some hardliners were frustrated Iran had made as many compromises as it had; Hossein Shariatmadari, the influential archconservative editor of the Kayhan daily, said that Iran had traded a “ready-to-race horse” for a “broken bridle.” Yet many of Shariatmadari’s biggest ideological adversaries outside Iran appear just as disappointed. In addition to the Israeli government, Republican leaders in the U.S. have been quick to condemn the deal as allowing Iran too much leeway for nuclear activity and as having too short a timeframe. Furthermore, Republicans and some Democrats in the Senate are close to reaching a veto-proof majority for a bill that would give Congress the ability to reject the White House-brokered deal. While these actors could rally opposition against a final deal, perhaps the skeptics with the greatest influence in the oil market are Sunni-led Arab States, led by Iran’s regional rival, Saudi Arabia. While the months after a final deal would see Iran slowly return exports to the global market that had been lost under U.S. and E.U. sanctions—and Oil Minister Bijan Namdar Zanganeh says Iran would be able to quickly add 1 mbd to the market—this downward effect on oil prices could be drastically mitigated by an increased risk premium if Iran’s neighbors feel vulnerable in the wake of a final deal and tensions rise in the Middle East. The potential for a heightened level of enduring tension and proxy war is already visible. Adding to existing rivalries in Syria and Iraq, last week, Arab forces led by Saudi Arabia began heavy military operations in Yemen in an attempt to halt and roll back the progress of the Iranian-supported Houthi rebel group that they claim is a proxy of Tehran. Seeing the potential for further conflict with Iran-backed groups, the Arab League announced plans over the last weekend of March to form a 40,000-strong joint military force, with Iran’s intervention “in many nations” cited as a motivating factor. Israel, meanwhile, has refused to rule out unilateral strikes against Iran’s nuclear infrastructure. The stakes could rise yet further. Saudi Arabia, a significant sponsor of nuclear state Pakistan, last week refused to rule out the acquisition or development of its own nuclear weapons capability. Meanwhile, ostensibly peaceful nuclear energy projects are planned or underway in Egypt, Turkey, Jordan, and the UAE, raising worries that if Iran is perceived as having an insufficiently limited nuclear program, the Middle East could see a nuclear arms race. While such tension could exacerbate smaller proxy conflicts such as those underway in Syria, Iraq, and Yemen, a worst-case scenario would involve a spillover into overt military action between Iran and Saudi Arabia or its allies. With each side possessing missiles capable of reaching across the Persian Gulf, strategic military and economic targets on both sides could be at risk. This would include coastal oil installations such as Saudi Arabia’s Abqaiq facility, the world’s largest oil processing plant with 7 mbd of capacity. And any major conflict could impede or halt traffic at two of the world’s biggest oil traffic chokepoints, the Strait of Hormuz between Iran and Oman and the Bab el-Mandeb between Yemen and Djibouti, sending the price of oil skyward. Approximately 17 mbd and 4 mbd of oil and petroleum products flowed through the Strait of Hormuz and Bab el-Mandeb Strait respectively in 2013 (combined equivalent to more than 20 percent of global oil demand). A more hostile, or potentially nuclearizing, Middle East would likely result in a larger, more enduring risk premium being attached to the prevailing global price of crude oil due to fears of deepening political instability, terrorism, and protracted regional conflict. These effects could be far greater than other recent examples of elevation in the risk premium, such as those of 2012 when Iran threatened multiple times to close the Strait of Hormuz unless sanctions against it were lifted, causing several short-term oil price spikes. With relations between countries in the region likely to deteriorate further, prices may remain permanently elevated in the event of similar threats or provocations; this will almost certainly increase the risk of disruption to oil supplies from a major producer. If such developments were to actually result in furtherand substantial disruption to oil supplies—particularly from Saudi Arabia, which today produces approximately 10 mbd (more than 10 percent of global production) and holds the vast majority of global spare oil production capacity—the impact on prices would be still more meaningful and potentially long lasting. In physical terms, an Iran deal, if fully implemented, will add barrels of oil to the global market and exert downward pressure on world prices. But with many skeptics remaining, particularly in the region, fears of conflict that would prompt major supply disruption are likely to usher in an era of both prolonged tension in the Middle East and constant and elevated risk premiums, with the price of oil ready to shoot even further upward in the wake of any clash in the region.
May 12, 2015