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Oil: Iran Risk Vs. Russia Risk

Published 02/18/2022, 06:29 AM
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Oil traders, what will you go with it? Iran risk or Russia risk? 

Whatever you pick, it probably isn’t going to be easy to stick to in the coming days and weeks. 

If you’re a momentum trader, then you’ll probably relish playing the volatility. 

But if you’re a directional trader, then that easy trade of the past two months—where crude seemed on a one-way ticket to $100 a barrel and beyond—has become trickier. 

Oil Daily

To be fair, triple-digit pricing could still happen anytime. Headlines even remotely suggesting an advance or buildup of Russian troops targeted at Ukraine are capable of adding anywhere from $3 to $5 to the price within minutes. 

And while a single missile hasn’t been fired in the conflict, crude has gained some $20 over the past 10 weeks, mostly from the war of words between the United States and Russia since the Ukraine crisis erupted on Nov. 21.  

But as swift as the price breakouts have been on headlines of aggression, so too were the tumbles that came on suggestions of mediation. 

The pendulum has swung even more wildly over the past 48 hours as Tehran inched towards reviving its 2015 nuclear deal with world powers that would eventually take US sanctions off its oil—and pave the way for the legitimate return of some one million barrels per day from Iran to the market.

Brent Oil Daily
As John Kilduff, a partner at New York energy hedge fund Again Capital, put it at Thursday’s close: 

“There are just so many unknowns in the Russian-Ukraine stand-off that each trade might not last beyond the next headline.”

“Given these extremely challenging circumstances and volatility, traders have opted to keep a limited risk upside on oil—i.e. $90 support—while focusing on the ‘now’ in the trade, which is the possibility of the Iran deal.”

In fact, Iran and Russia's risks are polar opposites—the first represents a bear case (more barrels eventually from Tehran) and the second a bull case (US sanctions on Russian energy exports in the event of an invasion)—so it pays to examine the permutations in each. 

Iran Risk/Bear Case

Nuclear Non-Enrichment 

The draft of the enhanced accord offered by Western powers to Iran suggests various phases of surveillance and engagement to bring Tehran back into compliance with its 2015 nuclear agreement.  

Most importantly, according to Reuters’ reports on the draft, Iran has to immediately stop further uranium enrichment that would advance it toward achieving full bomb-grade capability. 

Only if it can withstand that stick, would the carrot follow, i.e., billions of dollars of previous oil sale money legitimately withheld from the Islamic Republic’s coffers and the gradual removal of sanctions that would let it export its oil freely—albeit with continued monitoring of its nuclear commitments.

Tehran breached many restrictions in the 2015 agreement after former President Donald Trump pulled the US out of the pact and reimposed sanctions on Iran. While the original accord capped uranium enrichment at 3.67% fissile purity, Iran is now enriching to up to 60%, close to weapons-grade, according to sources quoted by Reuters. Nuclear Deal 2.0 calls on the Mullahs to suspend enrichment at above 5% purity and return to the core 3.67% eventually.

  • The main recurring points of discontent in the Iran-world powers talks of the past year have been the West’s definition of Tehran nuclear program; its allegations about levels of nuclear enrichment that have transgressed limits and the preconditions that the republic must meet for sanctions liftoff. 
  • Iran insists its nuclear aims are wholly peaceful and that it wants to master the technology for civil uses. Few outside the country believe that, of course. Based on the strenuous draft accord, Tehran might continue arguing for an unconditional sanctions liftoff, promising to abide by all rules later. This could be the main sticking point and if neither side yields, it could again kill a deal. If Iran's top nuclear negotiator, Ali Bagheri Kani, is to be taken to his word, “nothing is agreed until everything is agreed." Yet, it was also Kani who announced jubilantly this week that “we are closer than ever to an agreement.” That tweet of his sent crude prices down almost $5 a barrel at one point. As French Foreign Minister Jean-Yves Le Drian told his parliament, "Political decisions are needed from the Iranians. Either they trigger a serious crisis in the coming days, or they accept the agreement which respects the interests of all parties. We have reached (the) tipping point now. It's not a matter of weeks; it's a matter of days" for a deal. So, an agreement could still be reached under extraordinary circumstances.

$7 Billion Bonanza From South Korea 

One of the relief measures for Tehran under the proposed new accord is unfreezing of about $7 billion in Iranian funds stuck in South Korean banks under the sanctions imposed by Washington. This is to be in exchange for the release of Western prisoners held in Iran, which US lead negotiator Robert Malley has suggested is a requirement for a deal. 

  • Talks took place in Seoul this week on South Korea’s plan to resume oil imports from Tehran while negotiations were being held simultaneously in Vienna for the Nuclear Accord 2.0. Also on the table was the topic of unfreezing Iranian funds held in South Korea, the East Asian country’s foreign ministry said. South Korea was previously one of Iran's leading Asian oil customers. This has all the signs of an advance plan by Iran to tee up South Korea as one of its first customers upon a sanctions liftoff. Tehran’s need for money is also a powerful motivator here.
  • Iran is likely to agree to this cash-for-prisoners exchange. As aforementioned, the money would be extremely helpful for Iran’s immediate economic needs (its detractors would argue that the cash would further enable the Islamic Republic to act against Israel and Western interests). But we could also look at Iran reinvesting a significant portion of the money towards rebuilding its oil industry. This would help it bulk up production beyond current capacity and challenge others within OPEC and the extended OPEC+ for more market share. More barrels from Iran would mean more downward pressure on crude prices.

Millions of Iranian Barrels In Bonded Storage In China

  • Some 12 million to 14 million barrels of Iranian crude are estimated to be held as “bonded storage” in Chinese ports, awaiting the US go-ahead for them to be put to commercial use. The oil made its way to China before the reimposition of sanctions on Iran by Trump. China keeps the crude in “bonded storage,” which means the oil has not been cleared through Chinese customs and is not being used, therefore not yet violating the sanctions. Back in August 2019, Again Capital’s Kilduff reported that crude prices could fall by $5 to $7 a barrel if China were to draw down on these stored volumes. Depending on when these barrels get released, crude prices might fall just as much as Kilduff speculated or maybe more. 

Sanctions Liftoff—How Much Will Iran Put On The Market?

  • As in the original nuclear deal, officially called the Joint Comprehensive Plan of Action, the new agreement entails the US granting waivers to sanctions on Iran's lifeblood oil sector rather than lifting them outright. That requires renewing the waivers every few months. One Middle Eastern diplomat, briefed on the Vienna talks, told Reuters: "Oil exports, under the deal, former US President Barack Obama and Trump used to issue 90- to 120-day waivers and renewed them consistently until Trump stopped after exiting the pact. Those waivers have been agreed to be issued again." Iran should have no problems agreeing to this. But the question remains: How much can it put in the market over the next year? The answer, for now, seems to be the same conservative estimate of one million barrels per day. It is probably exporting as much already through backdoor channels and lax enforcement of Trump’s sanctions by the Biden administration. At the height of the non-sanctions years, Iran produced as much as 4 million barrels daily at one point, though its capacity now is more likely at 2 million. 

Likely End To OPEC+ Production Cuts

  • Oil prices are important to producers but even more important is market share. With the return of a hungry and competitive Iran to the crude market, OPEC+ production policy, as we know it, will likely see a radical change with the end of output cuts that had shaped pricing and demand in the market since its lows of COVID-19. Iran might not have even half of the Saudi, UAE or Russian production to hold the market to ransom. But Iran’s crude is comparable in quality to Saudi Arabia’s. Iran also has historic relationships in oil with China, South Korea and Japan. And the mere fact that it will compete for every barrel that can be sold will make the rest of OPEC+ extremely wary of making any production cutbacks. Those struggling now to meet their OPEC+ approved quotas might make more effort in meeting those targets.

Price Undercutting 

  • One way for Iran to quickly win market share for its oil will be to undercut Saudi pricing on crude and Tehran could offer deep discounts of as much as 10% to 15% off current market rates. At $92 a barrel for Brent at the time of writing, the discounted Iranian barrels could land at $78-83. Iran can afford to sell its oil at deep discounts, at least initially, because it does not have a massive national budget like the Saudis, who need prices to be at $80 or higher. As Iran discounts, international prices of crude will come under pressure too. 

Higher US Production, Though Not Too High

  • It has been one of the most debated issues in the oil industry over the past two months: When will US shale oil and the “Drill Baby, Drill!” phenomenon return to the market? Shale’s discipline in keeping production as tight or even tighter than the Saudis (thanks in part to the Biden administration’s preference for green fuels over fossils) has won the admiration of the kingdom’s Energy Minister who proclaimed a year ago that “Drill Baby, Drill!” was probably gone forever. The CEOs of top local drilling names like Continental Resources (NYSE:CLR), Pioneer Natural Resources (NYSE:PXD) and Devon Energy (NYSE:DVN) swore in a Bloomberg story on Thursday that even $200 oil will not result in overdrilling. But the economics of even $90 crude is far too tempting for private equity shops not to bankroll another generation of independents into the game. For sure, US production is rising this year and could reach pre-pandemic highs by 2023.

Russia Risk/Bull Case

Threat of Ukraine War/Sanctions on Russia

  • As aforementioned, the specter of war and threat of massive and far-reaching US sanctions on Russia, hitting Moscow’s oil exports among other things, would be incredibly bullish for crude. Washington and its allies in Europe are finalizing an extensive package of sanctions if Russia were to launch an invasion, Reuters reports, citing US and European officials. The speculation is that crude could go from a current intraday low of $90 to $125 in a matter of days if war does break out between Russia and Ukraine. This one element alone will override any bearish factor in oil, including Iran’s return to the market.

‘Win-Win-Win’ For Russia, Saudis And Iran?

  • There’s always this possibility: Russia continues to keep the world guessing about its next actions, providing an extended climate of geopolitical fear that works great for oil prices. The Saudis, meanwhile, keep their premium pricing on crude; and Iran, on its re-entry to the market, will do whatever it needs as well to grow market share without necessarily hurting anyone else in OPEC+, including arch-nemesis Saudi Arabia. And if oil hits $100 and beyond, it’s a ‘win-win-win’ for all three.

World Oil Demand Goes Ballistic; Supply Stays Rock-Bottom

  • The Paris-based International Energy Agency, which habitually makes bearish forecasts on oil demand, given its focus on consumers, has made a 180-degree turn, agreeing with OPEC+ that demand will be higher in 2022 than any supply can possibly mitigate. The IEA lifted its forecast for this year’s global oil demand by 800,000 barrels a day to 3.2 million barrels. This is one of the most bullish legs ever for crude to stand on. With this year’s possible end to the pandemic—as we know it—higher oil prices could be here to stay for now.

Disclaimer: Barani Krishnan uses a range of views outside his own to bring diversity to his analysis of any market. For neutrality, he sometimes presents contrarian views and market variables. He does not hold a position in the commodities and securities he writes about.

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