On Monday morning, U.S. Secretary of State Mike Pompeo announced that the U.S. government would be ending all significant reduction exemptions (SREs) for purchasers of Iranian oil. This means an end to any exemptions that had permitted selected countries to purchase designated amounts of oil from Iran over the last six months. From now on, any country that purchases oil from Iran after May 1 is expected to face secondary sanctions from the U.S.
When news of the impending decision came out on Sunday night, oil futures immediately started to rise. By the time trading closed on Monday, Brent was up by 2.8% to $74.04 and WTI increased by 2.7% to $65.70. Most traders and analysts did not expect the Trump administration to end all of the exemptions—some reductions were anticipated, but given President Trump’s desire to keep oil and gasoline prices low, the abrupt end to all exemptions was not seen as a likely move.
How much Iranian oil can we expect to come off the market?
The U.S. government claims that Iran is currently exporting 1 million bpd of oil and that maximum pressure is being put on importers to end their purchases of Iranian oil. However, non-governmental tracking services indicate that there is significantly more Iranian oil on the market. Data for March show that Iran exported anywhere from 1.7 million (Platts) to 1.9 million (TankerTrackers) bpd of oil and oil equivalent. China is the largest single importer of Iranian oil right now.
It is likely that South Korea, Japan, Turkey and India (the other importers of Iranian oil) will comply with the U.S. sanctions. That would take possibly 700,000 bpd of Iranian oil off the market. However, China is likely to continue some imports despite the sanctions. There are over 20 million barrels of Iranian oil sitting in bonded storage in Dalian, China, that China will want to draw on, and only a small amount of that oil has been accessed so far. China will be especially motivated to buy Iranian oil at discounted rates as oil prices rise.
How will that oil be replaced?
According to the State Department,
“Oil markets are well supplied and oil inventory levels are seasonally strong” while the U.S. has “commitments from oil producing countries, including the Kingdom of Saudi Arabia and the United Arab Emirates, to increase oil production to offset reductions in Iranian oil exports.”
However, Saudi Arabia’s oil minister, Khalid al Falih, responded on Wednesday saying that he doesn't see a need to raise oil production immediately. Instead, Saudi Arabia will respond to customer demand. Falih expects that demand for Saudi oil will rise with tightening sanctions on Iranian oil, but he will not be increasing oil production preemptively. Whether OPEC and its non-OPEC allies plan to increase production in the second half of the year will be discussed at the June meeting in Vienna.
There is clearly a disconnect between what the United States thinks Saudi Arabia and the UAE will provide and what Saudi Arabia is prepared to produce. There is no doubt that Saudi Arabia and the UAE are capable of making up lost barrels, but it is clear that these producers only intend to supply what customers demand, and will not replace Iranian oil barrel for barrel.
What are the short-term and long-term outlooks?
There is a variety of scenarios for the oil market. As Iranian oil exports drop, prices will rise. The question, of course, is: how much? This depends on the amount of pressure the United States puts on Saudi Arabia to produce and how much Saudi Arabia resists that pressure. Russia is also looking to increase its production this summer. When OPEC and its non-OPEC partners meet in Vienna at the end of June, it is possible that the production agreement could fall to shambles. In that case, many producers will feel pressure to put as many barrels as they can on the market—a move that will drive prices down. On the other hand, OPEC, with Russia’s assistance, might agree to maintain quotas with only a modest increase in production, and that would keep prices from soaring too high or going too low.
Of course, U.S. production is another important factor. If WTI holds on to its recent gains and new pipelines come online as scheduled, U.S. supply could also help replace the light-crude oil and compensate exports lost from Iran. U.S. output has already reached record levels in recent months, and there is no consensus on how much higher it can go.