The Known Unknowns of US Sanctions Against Iran

ANATOLE KALETSKY

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The sanctions against Iran reinstated by US President Donald Trump raise two all-important questions that have no convincing answers. But they also raise a third question, about which financial markets are likely to be wrong. BEIJING – The sanctions against Iran reinstated by US President Donald Trump raise two all-important questions that have no convincing answers. First, will this action make the world safer, as Trump claims, or will it further destabilize the Middle East and undermine future efforts to limit nuclear weapons, as argued by most geopolitical experts not directly employed by the US, Israeli, or Saudi governments? And, second, will US efforts to compel foreign companies to observe its sanctions against Iran prove as tough as Trump’s belligerent rhetoric?

The Iran sanctions could of course turn out to be an empty gesture. As a former Chinese ambassador to Iran recently put it: “For more than a year, Trump’s diplomacy, from the North American Free Trade Agreement, the Trans-Pacific Partnership trade pact and the Paris climate deal to the Korean Peninsula nuclear issue and the Syrian civil war, can be described as loud thunder but little rain.”

Still, the question of war and peace is impossible to answer. Fifteen years of Middle East chaos unleashed by the 2003 Iraq war have taught the world one indisputable lesson: nobody in the White House, the CIA, Mossad, or the Saudi intelligence services has a clue as to what might happen next in the region.

The commercial question is also hard to answer, for a simpler reason: The real extent of sanctions enforcement will not be clear until the late stages of the six-month “wind-down period” provided by the new US regulations for businesses to disengage from Iran.

But at this early stage in the US-Iran confrontation, another, even more important, economic question is worth considering: What will the US sanctions do to the price of oil?

At first sight, the answer seems too obvious to bother discussing: The oil price will surely rise as sanctions curb Iran’s output and exports, while traders brace themselves for a possible war. But financial markets have a disconcerting habit: predictions viewed by investors as completely obvious often turn out to be wrong. The outlook for oil prices could turn out to be such a case, for several reasons.

Oil prices are already 70% above their level last summer – and expectations of US sanctions against Iran have been an important driver of this surge. To “buy on the rumor and sell on the news” is a time-honored principle of financial speculation. Unprecedented recent purchases of oil contracts by non-commercial speculators in the New York and London futures markets suggest that sanctions may already be priced in, with Brent oil trading at $78 a barrel.

This price had never risen above $70 since 2014, when the upsurge in US shale production caused oil prices to collapse. And oil for future delivery in 2020 still costs well below $70, creating an unusual market condition called “deep backwardation,” which was last seen in the autumn of 2014 and often presages a steep price decline.

Turning from speculative conditions to the fundamentals of oil production, it is far from clear that sanctions will reduce Iran’s exports sufficiently to affect the global balance of supply and demand. While Iran’s exports almost doubled after the previous sanctions were lifted in 2015, from 1.5 million barrels a day to around 2.5 million barrels currently, most of this oil has been sold to China, India and Turkey, all of which are likely to ignore or circumvent US sanctions.

The genuinely vulnerable part of Iran’s oil trade are exports of just 750,000 barrels daily to the European Union, South Korea, and Japan. The EU has promised to protect its trade with Iran, but even if this proves impossible, much of the Iranian oil now flowing to Europe, Japan, or other US allies will doubtless be diverted to countries such as India and China, which will free up more Saudi, Iraqi, or Russian oil for Europe and Japan.

The fact that oil traders constantly redirect oil cargoes around the globe explains why most analysts expect sanctions to reduce global oil supplies by less than 500,000 barrels a day. A shift on this scale would be smaller than the 700,000-barrel collapse of Venezuelan oil exports since last year, and much smaller than the increase in US daily output of 1.1 million barrels projectedover the next 12 months, not to mention the probable reduction in global oil demand caused by the sharp increase in prices since last summer.

In short, the Iran sanctions will have less impact on the global balance of supply and demand than the performance of the world economy and the behavior of other oil producers. This suggests another reason why the US-Iran confrontation could lead to lower, not higher, prices: Trump and his Saudi allies now have a very strong political incentive to resist further upward pressure on oil prices.

Rising gasoline costs have already reversed almost half the gains from this year’s tax cuts for middle-class Americans. If oil prices rise much further during the summer “driving season” that starts in the US about now, Trump will be blamed by voters and Republicans could suffer in November’s midterm congressional elections, especially in Midwestern swing states.

Assuming that Trump now finds it politically expedient to curb oil prices, the Saudi leadership can be expected to offer him whatever support he requires. On the other hand, Iran and Russia, which had previously been less hawkish than Saudi Arabia about OPEC pricing, might now support tougher supply restraints, precisely because a sharp rise in oil prices could cause a punishing backlash against Trump.

Past experience suggests that US and Saudi political interests are likely to prevail, at least in the short term. That was certainly true after the two Iraq wars. Oil prices plunged by 45% in1991, and by 35% in 2003, within a month of the US launching its attacks. A fall on this scale seems inconceivable today, but oil prices are likely to head downward, despite the Iran sanctions – or maybe because of them.