Iran and Oil Prices in 2018

The turn of the year brought the usual year-end analyses of energy events, along with predictions and issues to watch in the year to come. I tend to focus on tallies of risks and large uncertainties. There's no shortage of those this year, and the current unrest in Iran moves the risks associated with that country higher up the list, at least for now.

The implications of instability in Iran extend well beyond oil prices, but let's focus there for now. The sources of instability include both the internal economic and political concerns apparently behind the protests, as well as US-Iran relations and the fate of the Iran nuclear deal and related sanctions.

As former Energy Department official Joe McMonigle noted, a decision by President Trump to allow US sanctions on Iranian oil exports to go back into effect could remove up to one million barrels per day of crude oil from the global market. He sees the protests making the reinstatement of sanctions likelier. Whether that would lead directly to much higher oil prices is harder to gauge.

A little history is in order. Sanctions on Iran, including those covering the receipt of Iranian oil exports, were one of the main tools that brought its government to the nuclear negotiating table. For a roughly three-year span beginning in late 2011, international sanctions reduced Iran's oil exports by more than one million barrels per day, at a cumulative cost exceeding $100 billion based on oil prices at the time. The effectiveness of those sanctions was also enhanced by the rapid growth of US oil production from shale. 

Starting in 2011, expanding US "tight oil" production from shale began to reduce US oil imports and eased the market pressures that had driven oil back over $100 per barrel as the world recovered from the financial crisis and recession of 2008-9. In the process, shale made it possible for tough oil sanctions to be imposed on Iran and sustained without creating a global oil price shock.

Instead, oil prices actually declined over the period of tightest sanctions. By 2014 US oil output had grown by more than Iran's entire, pre-sanctions exports and cut US oil imports so much that OPEC effectively lost control of oil prices. Seeking to drive shale producers out of the market, OPEC's leadership switched tactics and attempted to flood the market, driving the price of oil briefly below $30. That cut even further into Iran's already-reduced oil revenues and put the country's leadership in an untenable position, forcing them to negotiate limits on their nuclear program. 

If Iran's oil exports were to drop again this year, for whatever reason, the impact on oil prices would depend on the extent to which the factors that allowed us to absorb such a curtailment just a few years ago have changed. One measure of that is that after several years of painfully low prices--at least for producers--the price of the Brent crude global oil benchmark is now well over $60. Yesterday it flirted with $68/barrel, a three-year high. 

That recovery is the result of a roughly 18-month slowdown in US oil production in 2015-16, an agreement between OPEC and key non-OPEC producers like Russia to cut output by around 1.2 million barrels per day, and production problems in places as diverse as Venezuela and the North Sea.

These events have largely put the oil market back into balance and worked off much of the excess oil inventories that had accumulated since 2014. Commercial US crude oil inventories, which are among the most transparently reported in the world, have fallen 100 million barrels since their peak last spring. However, they remain about 100 million barrels above their typical pre-2014 levels. 

Viewed from that perspective, a reduction in supply from any source might be exptected to send prices higher. However, although global oil demand is still growing, we should realize that today's tighter oil market is largely the result of voluntary restraint, rather than shortages. Potential production increases from the rest of OPEC, Russia and the US could more than compensate for another big drop in Iran's oil exports.

In particular, US shale output has been climbing again for the last year, boosted by rising prices and the amazing productivity of the venerable Permian Basin of Texas. Meanwhile, production from the deepwater Gulf of Mexico is also increasing as projects begun when oil was still over $100 reach completion. In its latest forecast the US Energy Information Administration projected that US crude production will reach an all-time high averaging 10 million barrels per day this year. Despite that, US shale producers still have thousands of "drilled-but-uncompleted" wells, or DUCs, waiting in the wings. 

So, short of instability in Iran morphing into a regional conflict involving Saudi Arabia and the other Gulf producers, oil prices might drift higher but would be unlikely to spike anywhere near $100. And that's without factoring in the scenario suggested by the Financial Times' Nick Butler, who proposes that the Iranian government might choose to break the OPEC/Russia deal and increase their oil exports, in order to boost their economy and mollify the protesters, thereby shoring up the regime. 

The last point brings us back from a narrow focus on oil prices to larger geopolitical uncertainties. As a noted Iran expert at the Council on Foreign Relations recently observed, Iran's religious government faces challenges similar to those that led to the collapse of the Soviet Union.

It's far from clear that 2018 will be Iran's 1989, or that President Rouhani is capable of becoming his country's Mikhail Gorbachev. Yet surely the 2015 nuclear agreement was a bet by the US and its "P5+1" partners that Iran would be a very different nation by the time its main provisions start to expire in the next decade. The whole world would win if that prediction came true.

On that note I'd like to wish my readers a happy start to the New Year. My top resolution is to post here more frequently and more regularly than in 2017. 

Will Russia's Gas Deal with China Block Other Suppliers?

• The recent natural gas deal between Russia and China involves volumes comparable to the gas production of the US Gulf of Mexico.
• Barring a major economic slowdown, meeting China's projected growth in gas demand will require this Russian gas, more LNG imports, and China's own shale gas.

 

$400 billion deals aren't announced every week--even by heads of state--although the new natural gas supply agreement between Russia and China had been in the works for some time. However, the crucial element of price apparently wasn't agreed until a negotiating session that lasted until 4:00 AM, Shanghai time. "Our Chinese friends are difficult, hard negotiators," said President Putin. They certainly waited for the right moment, with Russia pressed by sanctions in the aftermath of its annexation of Crimea.

The numbers are all impressive: After investing more than $50 billion in gas field and pipeline development in Eastern Siberia, Russia will sell 38 billion cubic meters (BCM) of gas per year to China for 30 years, and China will reportedly invest $20 billion for gas infrastructure and market development within its borders. Deliveries are set to start in 2018 and could eventually ramp up to 60 BCM/yr.

To put that in perspective, 38 BCM/yr equates to 3.7 billion cubic feet (BCF) per day. That's on par with the entire natural gas production of the Eagle Ford shale formation in south Texas, or the federal waters of the Gulf of Mexico.  Of greater relevance is that it's also nearly twice the output of Australia's Gorgon LNG project, which is expected to begin production in 2015. So from the perspective of the regional gas market and alternative supplies, this is a very significant quantity of gas, especially with a number of new Australian LNG projects under development or consideration.

As of 2012 China's gas market was already the largest in Asia, ahead of Japan, based on BP's annual Statistical Review of World Energy. This deal represents 27% of China's current gas demand, so it's tempting to conclude that squeezing Russian gas into China must come at the expense of other potential suppliers. If China's gas market were mature, such a zero-sum view could not be ignored, particularly by marginal LNG projects in Australia, Indonesia and the US that have not yet begun construction.

Competition with Russian gas could also impede development funding and access to infrastructure for China's nascent shale gas industry. The US Energy Information Administration's 2013 global survey of technically recoverable shale resources found that China could have over a quadrillion cubic feet--1,115 TCF--of shale gas in the ground, or nearly twice as much as the US. Yet China's progress in tapping this resource has been slow, and hardly a week goes by without another article explaining why it will be difficult if not impossible for others to replicate the US shale gas boom any time soon.

The growth of demand will largely shape the competitive environment for gas in China. In 2012 natural gas accounted for less than 5% of the country's total primary energy consumption, compared to 13% for Taiwan, 17% for South Korea and 22% for Japan, none of which are significant gas producers. From 2007-12 China's gas market grew at a compound average rate of 15% per year. In their just-released Medium-Term Gas Market Report, the International Energy Agency (IEA) forecasts China's gas demand growing by 90% by 2019, while their latest World Energy Outlook anticipated it tripling by 2025 and quadrupling by 2035, eventually reaching 11% of energy consumption. Achieving that would require the equivalent of ten gas deals the size of this one.

That outcome isn't a certainty, for many reasons. Having all that gas turn up at the right time poses a massive logistical and capital investment challenge, and China's economy might slow further. Meanwhile, the price implied in the media coverage of the Russia/China deal is around $350 per 1000 cubic meters ($10 per million BTUs) or more than double the current US wellhead price. That's a lot cheaper than most of the LNG delivered to Asia, but it won't outcompete Chinese coal on economics alone, and it won't jump-start new, gas-reliant industries the way the US shale gas revolution is beginning to do.

The scale of market development implicit in the IEA's forecasts for China would require a substantial expansion of gas-fired power generation, which in any case is the logical complement to China's aggressive expansion of wind and solar power installations. It also entails a significant shift from solid and liquid heating and cooking fuels to gas, where at least in the case of liquids, $10 gas would have the edge over products derived from $100 oil. It might even encompass gas-based distributed power generation using fuel cells, which is still in its infancy in the US. Such developments will benefit all potential suppliers, not just Russia.

It's also worth considering what this deal means for Russia. While many reports have suggested it provides a counterweight to Russia's dependence on the European gas market, that's really only true in a financial sense. The deal represents a major growth opportunity for Gazprom, Russia's majority-state-owned natural gas company, but this isn't the same gas that now supplies the EU. It will mainly be production from new gas fields. The potential upside for Russia may depend on its ability to leverage the infrastructure built for this deal into a larger gas network for supplying growth throughout Asia--in competition with US and other LNG projects eyeing that market.

"Milestone" is an over-used term, but it fits this deal. If the parties can iron out all the remaining details and proceed to construction and ultimately delivery, it could prove to be a key step in giving gas a much bigger role in fueling Asia's growth. That would have important environmental benefits, in both mitigating the air pollution in Asia's major cities and reducing carbon emissions, perhaps by enough to bend the curve of the region's greenhouse gas growth.

 

A different version of this posting was previously published on the website of Pacific Energy Development Corporation.

The Cost of A Tougher Iranian Oil Boycott

Today's Wall St. Journal (subscription required) includes an op-ed calling for a stricter US boycott of Iran than the current one that prohibits importing Iranian oil. The proposal from Reuel Marc Gerecht and Mark Dubowitz of the Foundation for the Defense of Democracies would go a step farther, barring the importation of petroleum products that contain any components processed from Iranian crude elsewhere. Before any fuels or petrochemical products could be brought to the US, exporters "would have to certify that no Iranian oil was involved in its manufacture." Yet while the authors have clearly thought about how to maximize the impact of such a rule on the government of Iran, I'm not sure they've examined the potential impact on the US carefully enough. If their arguments about how European refiners would react to such a boycott are correct, then U.S. gasoline prices would likely rise as a result of these restrictions.

The logic of the proposal is grounded in fact. The US imports significant quantities of gasoline from Europe, though lately most of it is in the form of gasoline blending components, rather than finished gasoline that is ready to be put into a pipeline or sold over a refinery's or blending facility's truck rack. Last year total US gasoline imports averaged almost 900,000 barrels per day, with 39% coming from EU countries led by the UK, Netherlands, Spain and France. It's also true that many European refineries process some Iranian crude. In 2010, the EU imported 471,000 bbl/day of crude oil from Iran, comprising just over 4% of total EU oil imports of 11.1 million barrels per day. (Compare that to US oil imports in 2010 of 9.2 million bbl/day.) This amounts to roughly a fifth of total Iranian crude oil exports. At least on the surface, it looks like it shouldn't be too hard for European refiners to forgo this small input, in order to be able to continue exporting gasoline and other oil-derived products to the USA.

In practice, I think it would be more difficult for European refiners to make that adjustment than the authors imagine. For starters, those refineries capable of exporting gasoline to the US must generally be located near ports, rather than inland, and likely run more Iranian crude than the EU average, since this oil is delivered by large tankers. Then there's the question of how much Iranian crude a refinery could run and still be able to certify its products to be Iran-free. If the standard were simply that you couldn't export a larger proportion of your products than the proportion of non-Iranian oil in your crude slate, that probably wouldn't change what any refiner is currently doing, since most of their output goes into the local market. Certifying that there were no molecules of Iranian origin in any products destined for the US would essentially require running no Iranian crude at all, because of the way that most refineries operate and manage their inventories of crude oil and unfinished products.

I presume that's what the authors have in mind, because it would certainly exert the greatest market pressure on the price of Iranian crude. However, substituting one crude oil for another in a refinery isn't like substituting one brand of cola for another in a fast-food restaurant. We've seen a prime example of that recently with the disproportionately large disruption caused by the curtailment of exports of high-quality oil from Libya. Refineries tend to be optimized around certain proportions of well-known crudes, with shifts in those proportions mainly driven by changes in the value of the products they yield, within a range set by the capabilities of the specific hardware. In other words, if your refinery model is telling you to run x% of Iranian Light, then choosing something else in order to be able to sell into the US market comes at a cost.

That cost would be passed on to companies importing European gasoline into the US in two ways. First, it would require a higher price to make it worthwhile for the exporting refinery to produce a cargo to US specifications. Less directly but just as significantly, it would reduce the number of refineries competing for the export opportunity, because some would simply find the changes too onerous, unless the premium they collected was really large. That would create a smaller pool of suppliers with higher costs. That's not what you want to face as a buyer.

Market dynamics might also amplify this effect. A portion of the gasoline exported from Europe to the US flows not under long-term contracts, but as "spot" cargoes shipped in response to occasional wide price differences between there and here. That's exactly the kind of trading I was involved in when I worked in London in the early '90s. Such "arbitrage opportunities" often result from supply problems such as refinery accidents and other unanticipated shutdowns, large weather events, or other situations leading to a local or regional price spike. As a result, much of the impact on the US from the authors' proposal could be delivered when gas prices here would already be rising, thus adding to the economic impact of a price spike.

Perhaps paying more at the pump to drive down the value of Iranian crude in the global market is a price most Americans would be willing to accept. I'd gladly kick in a few cents per gallon for that purpose, since I remain extremely skeptical of Iranian assurances that their nuclear program is entirely for peaceful purposes. Nothing has materially changed my view of that since my detailed analysis in 2005. However, I suspect that the strong likelihood that such a boycott would entail a certain amount of "blowback" at home would complicate the politics of passing the necessary legislation, particularly when gas prices are already quite high by US standards.

Iran and Oil Price Risk

Today's UN Security Council vote on a further round of sanctions on Iran merits attention. While the U.S. and its key allies were able to get a somewhat diluted slate of new sanctions passed, the vote may be as notable for the "nays" cast by Brazil and Turkey as for the "ayes" it received from Russia and China, along with Lebanon's abstention. It looks like Iran has astutely leveraged the fraying of traditional alignments following the global economic shake-up of the last two years. The significant recent deterioration of Israel's image and standing probably played a backstage role, as well. It's a toss-up whether this new configuration makes an eventual confrontation over Iran's nuclear program more or less inevitable than previously.

Tensions over Iran's nuclear program have been moderated somewhat by ongoing diplomatic initiatives that have fragmented into parallel conversations between Iran and the US plus its closest European allies, Iran and its neighbors, and Iran and various emerging and non-aligned countries. However, jaw-jaw aside, Iran is either moving inexorably towards a nuclear weapons and delivery capability or putting on a pretty convincing Potemkin show of this for its own inscrutable reasons, reminiscent of Saddam Hussein's WMD sham of a few years ago. Either way, this still looks like the biggest unresolved political risk hanging over global oil markets, even if they're presently too distracted by the turmoil in currency and stock markets and the wave of offshore oil exploration bans emanating from the Gulf Coast leak to pay much attention to the risk of conflict.

This dance has been going on for years, but important elements have changed recently in ways that might alter calculations of the risks of a military strike by Israel--or anyone else--on Iran's facilities, relative to the risks of allowing Iran to produce a warhead and match it to its increasingly sophisticated missile technology. Last week's fiasco involving Israel's interdiction of a convoy of ships carrying aid to Gaza looms large, for several reasons. First, it has further isolated Israel from traditionally sympathetic countries in Europe and elsewhere. That could be crucial in the aftermath of any Israeli moves against Iran. In addition, Israel's action alienated low-key regional ally Turkey, not least because the convoy sailed from Istanbul and most of the fatalities were Turks. When Iran, Turkey and Russia meet to discuss regional security, it's a pretty clear sign that things are changing in noteworthy ways. (The slow drift of Turkey out of the western orbit after years of being rebuffed for EU membership may go down as one of the biggest missed opportunities of the post-Cold War era.)

As another Washington Post article indicated this morning, the latest sanctions might bite a little harder but could leave Iran's leaders feeling they have come out ahead in this round. If so, they won't be deterred to any greater extent from pursuing their oft-denied but widely-assumed nuclear aims. Meanwhile Israel has even less scope than before to launch an Osirak-style attack without facing a crippling response from its friends. As I noted last fall, the window of opportunity for resolving this slow-burn crisis without risking intolerable consequences for oil prices will not remain open indefinitely.