Orlando's Outlook: Iranian monkey wrench
Bottom Line: One of the critical underpinnings to our view that the U.S. economy will lift out of its current economic soft patch over the second half of this year is the positive impact that we expect on business and consumer spending from the sharp decline in crude oil prices we’ve seen over the past four months. To be sure, West Texas Intermediate (WTI) plunged by 30%, from $111 per 42-gallon barrel in early March to $77 in late June. Yet, the national average for a gallon of unleaded regular gasoline has fallen by only 15% to date, from $3.95 in early April to $3.35 in early July, which suggests that there may be some lagged catch-up to perhaps $3.00 per gallon or lower in coming months. Such a sharp decline in energy prices essentially serves as a quasi tax cut for businesses and consumers, which we believe will boost economic growth in conjunction with lower interest rates, a growing wealth effect from rising stocks prices, and the positive global economic impact from fiscal and monetary policy stimulus resulting from recent government and central-bank activity. But we are also concerned that the European Union’s (EU) embargo on Iranian crude oil, triggered on July 1, could throw a potential monkey wrench into our constructive view.
EU oil embargo a high-stakes game of chicken with Iran We had hoped that the threat of this embargo would persuade Iran to abandon its nuclear ambitions in exchange for the resumed trade of relatively cheap, high-quality Iranian oil, which could potentially drive WTI oil prices down below $77. But with the EU embargo now in effect, we see no progress in negotiations between Iran and the so-called “P5+1”—the five permanent members of the United Nations Security Council (U.S., Russia, China, France, and the United Kingdom) plus Germany. So the $64,000 question for investors is whether this issue gets resolved diplomatically or militarily? Will Iran abandon its ambitions for nuclear development, or take military action to enforce what it perceives to be its sovereign nuclear rights?
Commence the saber rattling As a means of flexing their military muscles, the Iranians have staged missile tests—with a self-described range to strike Israel and 35 regional U.S. air bases—over the past two weeks, and they’ve renewed their threats for a naval blockade for oil shipments through the Straits of Hormuz in the Persian Gulf, through which 20% of the world’s crude oil flows daily. Not surprisingly, jittery crude oil prices (WTI) have spiked by about 15% over the past fortnight, from $77 to $89, before settling back at $86 in recent days.
Is Iranian oil important to the U.S.? In a word, “No.’’ The U.S. has not imported any Iranian oil since 1992—despite the fact that Iran is the world’s third-largest producer—and we now produce domestically about 40% of the oil that we consume. Of the 60% that is imported, the Organization of Petroleum Exporting Countries (OPEC) sells us 40% (which has been steadily declining over the past five years), 19% comes from Canada and 8% from Mexico. Circling back to OPEC, Saudi Arabia is the swing producer, and it’s been furiously pumping 10 million barrels per day in recent weeks to flood the global market with crude oil in the event that the Iranian crude was embargoed from the marketplace.
Iran is in huge financial trouble The U.S. and E.U. economic sanctions are working, as Iran’s national budget is 80% financed by revenues from oil exports but the country is selling only at about 60%—and falling—of last year’s capacity. Moreover, 95% of the world’s tanker insurance companies refuse to cover any tanker holding Iranian oil, plunging Iran’s total exports to about 1.1 million barrels per day (bpd), versus an average of about 2.25 million bpd a year ago. Consequently, the value of Iran’s currency has already plummeted by 40% in the past year, falling by more than 15% in the past three weeks alone, with inflation estimated at between 50-60% for 2012. U.S. Secretary of State Hillary Clinton said that these sanctions will cost Iran $8 billion, or 10% of Iranian GDP, per quarter.
Iranian oil reserves almost at capacity With their storage capacity for crude oil on land at 10 million barrels already met, the Iranians have set afloat 40 million more barrels, which is the rest of their excess capacity, on two-thirds of their tanker fleet. So while the Iranian government tries to sell oil that nobody wants or can insure, they now must build extra storage capacity with money that they do not have. Only a third of Iran’s tanker fleet is still available, with a capacity of 20 million more barrels. Iran pumps between 2.8 and 3.0 million bpd, successfully exporting 1.6-1.8 million bpd, for a surplus that stacks up at a rate of 1-1.4 million bpd. So the rubber hits the road for Iran’s growing storage-capacity problems by the end of July.
Iranian citizens fed up Iran’s state-run television’s website recently posted an opinion poll which stated that 63% of Iranian citizens would prefer that the government stop the uranium-enrichment program in return for the removal of crippling economic sanctions. Shortly thereafter, the poll was removed and replaced with one about soccer. The television network later said that only 24% of participants favored abandoning nuclear enrichment for a return to economic stability. Food and consumer-staple prices have skyrocketed as a result of tightening access of raw materials through trade, and last month, the Iranian people organized a bread and dairy protest strike, which was 90% effective.
Longer-term U.S. impact How events in Iran play out this summer could very well have an important economic and political impact here in the U.S. Rising gas prices could clearly blunt the positive economic impact on business and consumer spending that we’ve been forecasting, due to the second-quarter drop in both crude oil and gasoline. If that actually happens, then our domestic energy policy—and the political hot potato represented by the Keystone XL pipeline—take center stage at the upcoming conventions and debates.
Potential outcomes: So, what might happen in Iran between now and year end?
Diplomatic stalemate and Iranian deprivation lasts until the election Highly unlikely due to the current economic hardships and citizen unrest in Iran, as well as Israel’s growing security unease as it would likely be the most threatened if Iran successfully produces nuclear weapons. Something is likely to break one way or the other in coming months. But this scenario could also potentially inject itself in our presidential election, with rabid discussion points on the efficacy of our current stance on defense, energy and fiscal policy and the resulting impact on the U.S. economy.
Iran recognizes the suffering of its citizens and abandons its nuclear ambitions This is the preferred win-win scenario, as the global energy market would flood with more oil, thus reducing gas prices and driving higher levels of domestic consumer spending and GDP.
U.S. and Israel take up arms against Iran This would only happen, in our view, in retaliation for a first strike by Iran against Israel. But the knee-jerk reaction would be sharply higher crude oil and gold prices, higher domestic inflation, slower economic growth—if not outright recession—and much lower equity prices.
Israel takes up arms against Iran alone The odds are low, in our view, for a so-called pre-emptive strike by Israel against Iran. The key points to consider would be the ensuing success or failure of the E.U. /U.S. oil embargo against Iran, the perceived progress that Iran is making on successfully constructing a nuclear weapon that could potentially destroy Israel, and Israel’s perception of unilateral military support from the U.S.
