Iran’s nuclear deal is a game changer.
On the one hand, it signals Iran’s re-entry into the Western sphere of influence. It’s reshaped Middle Eastern geopolitics overnight. But it’s significant for another reason too: oil.
That’s something Woodside [ASX:WPL] and Santos [ASX:STO] could have done without. The Aussie duo are small players on a global scale. Both are hurting from declining oil prices. And both have seen shares fall by $10 since November 2014.
But it’s not about to get any easier. Iran’s re-emergence is the biggest threat to any potential price recovery.
Iran has the world’s fourth largest proven oil reserves. It has an estimated 157 billion barrels of the stuff. That’s 40 times Australia’s proven reserves. That makes Iran’s re-entry onto global oils market a rather big deal.
From early 2016, Western sanctions on Iran will start to wind back. At that point, Iran’s oil production will increase. As will the amount of supply it forces onto global markets.
That’s either good or bad, depending on your point of view. For already depressed oil prices, it’s a disaster. Especially for the governments that rely on oil to underwrite budgets. At the same time, low oil prices will help the global readjustment to slowing growth. Low prices, for the foreseeable future, will help weather concerns about the global economy.
Not surprisingly, Iran will be the biggest winner from this development.
Since 2012, when sanctions first kicked in, Iran has lost half its market share. It’s selling roughly 1.2 million barrels of oil a day at present. That’s well down on the 3 million barrels it was selling prior to sanctions.
And it’s had to reduce output even as prices have weakened. A year ago, oil sold for US$110 a barrel. Today oil trades for less than US$50 a barrel. Brent crude oil is trading at US$48.02. WTI crude, meanwhile, is also at a low of US$44.72. Prices are down 45% on last year.
You can imagine the kind of pressure this forces on Iran’s budget. It’s pressured Iran to increase both oil and food prices. And the government has scrapped major infrastructure projects. Neither of which has gone down well with locals.
From Iran’s perspective 2016 can’t come soon enough.
But for Iran to return to 2012 production levels, it needs foreign investment and expertise. And that’s where the big oil companies come in.
The ABC reports:
‘Iran is a seriously attractive proposition now. For oil companies, the rates of returns are likely to be much higher than other investment possibilities around the world’.
Investing in Iranian oil has a lot of upsides. Both for itself and major oil multionationals. Especially for European firms removed from Middle Eastern politics. Companies like Russia’s Lukoil, Royal Dutch Shell, and France’s Total.
And Iran will need this investment.
These companies bring with them lots of experience. The kind of know-how that maximises investment returns.
It’s an easy decision for all parties involved. With oil prices at current lows, low cost opportunities like Iran don’t come around every day. As one oil executive put it, Iran is an ‘inescapable opportunity’.
The major producers know this. Which is why they’re lining up. Reports suggest Iran is struggling to keep up with requests for meetings.
With the nuclear deal, Iran is no longer an international pariah. But it’s a major threat to oil prices, and small oil producers.
Oil prices: what happens next?
New Iranian oil is both a threat and opportunity for oil markets.
As mentioned, major oil companies are big winners. Iran provides them a cheap option amid low prices. But they also know it’ll result in higher supply levels. Which is a problem in an oversupplied market. We shouldn’t expect this to change by the time Iranian oil makes its big comeback.
That leaves us with rising supply, coupled with already weak prices. The net result? Even cheaper oil.
The big question is how industry gatekeepers will respond. I’ll explain.
Predicting OPEC’s next move
The oil market has something of a supply and demand problem. It’s not so much that these forces aren’t at play here. But they’re operating counter to how we’d normally expect.
Any normal market, with weakening prices, would see supply fall to match that. If prices fall, there’s little point in maintaining high supply. Otherwise, prices either stay flat, or they continue falling.
But that’s not what we’re seeing with oil. The opposite of this is taking place. Oil supply is still rising even as prices remain at US$50 a barrel.
What we should be seeing is a tightening of global supply. If producers cut back on production, it would ease the pressure on prices. So why isn’t that happening?
It all comes back to the Organization of the Petroleum Exporting Countries (OPEC).
OPEC is an industry cartel that manages oil outputs and prices. Not every major oil producer is a member of OPEC. Russia isn’t a member for instance. Iran, on the other hand, is.
OPEC controls 80% of global oil reserves. It could send oil prices shooting back overnight if it wanted. But it hasn’t, and it’s not going to. It has put up with low prices even as its members come under budgetary pressures.
Why is it acting against its own interests? It isn’t, actually. It’s all a matter of perspective.
Oil prices are where they are because of market share driven strategies. Right now, OPEC is waging a war on competitors. Both within and outside the industry. It’s doing this for two key reasons.
For one, OPEC wants to maintain and expand its global market share. As prices fall, it makes sense to increase ones share of the pie.
Yet in doing this, they’ll come closer to achieving their second aim. OPEC wants to ruin the US shale oil industry. Its already driven out high-cost shale producers. But it hasn’t succeeded in killing it off entirely.
At the same time, it hopes to cancel out the threat of Iranian oil. At least, that was the plan before the nuclear deal was signed. Iranian oil would compete against OPEC’s oil. Even though Iran is itself an OPEC member.
That sounds strange at first. But you have to consider the politics at play. OPEC’s members aren’t traditional allies. It’s a coalition of convenience, more than anything.
At the head of the decision making process sits Saudi Arabia. It struggles with Iran for influence in OPEC. And that was easier when sanctions curbed Iran’s role in OPEC.
Iran’s re-entry will make it harder for OPEC to control output levels, and prices. Especially as Iran will want to increase its exports.
Iran was the second largest OPEC producer behind the Saudis before the sanctions. And it hopes to reclaim that position.
Does this mean that OPEC will cut back on production next year? Not exactly. OPEC is saying that next year will bring with it higher global demand for oil. To the extent that it absorbs Iran’s new oil outputs.
‘If production from non-OPEC slows down as expected and at the same time demand continues growing next, assuming that Iraq doesn’t increase big and Libya is not going to come back, then the market will absorb the Iranian oil’.
OPEC thinks global demand will rise by 1.34 million barrels per day in 2016. Yet Iran’s oil output could top 1 million barrels a day by the middle of next year. That alone would account for the rise in global demand that OPEC forecasts.
But there’s no sign that OPEC are prepared to let up on production. OPEC output reached six month highs recently.
We face the very real prospect of a long term price war. With Saudi Arabia and Iran at the heart of it. These two are major regional rivals in the Middle East. They may be part of the same organisation, but they won’t be seeing eye to eye on oil. This ensures oil prices will remain low. Perhaps even over the next 18–24 months.
The losers will be the smaller oil producers and OPEC.
The winners: Iran, major oil companies, and the global economy.
Contributor, Markets and Money
PS: Oil, like other commodities, is having a rough year. Commodity exporters have shed 5% on the ASX since early June. But the situation could get much worse before it improves.
The Aussie share market had its worst month since 2008 in August. The ASX lost 9% of its value, shedding more than $70 billion.
Markets and Money’s Vern Gowdie saw this coming. He predicted the current market correction at the beginning of the year. But Vern says we haven’t seen the worst of it yet. He’s convinced the ASX will lose as much as 90% of its market cap in the coming months.
Vern is the award-winning Founder of the Gowdie Family Wealth and The Gowdie Letter advisory services. He’s ranked as one of Australia’s Top 50 financial planners. Vern’s convinced the ASX could lose as much as 90% of its $1.8 trillion market cap. And that’s why he’s written ‘Five Fatal Stocks You Must Sell Now’ for you.
In this free report, Vern identifies the five companies which could destroy your wealth. It’ll surprise you to learn which blue chip stocks made his blacklist. And he’s identified one major commodity stock that could catch you by surprise. To find out how to download the report, click here.