The Weekly Report: Energy & Iran in 2012

17 January 2012


Many readers may be familiar with the film “300,” an adaptation of an ultraviolent graphic novel that depicts the historical Battle of Thermopylae where a few thousand Greeks (and 300 Spartans, hence the title of the movie) held off a substantially larger Persian force (estimates range between 70,000 and 300,000 soldiers) by using a highly militarized ultra-patriotic culture, and (most importantly) the terrain to their advantage.

What does “300” have to do with finance and investments? Honestly, not too much, except that you must be as tenacious and knowledgeable of the terrain as Leonidas, King of the Spartans, to invest in today’s environment. However, we can use “300” to explore some very heavy subjects in a somewhat light-hearted way. Coincidentally, both Greece (and the Eurozone as a whole) and Persia (now called Iran) figure heavily in global macroeconomic developments, so the “300” theme isn’t completely out of the blue.

Particularly, developments in Europe and Iran could lead to very large swings in energy prices. The risk of sovereign default or recession with the former, and military conflict with the latter, could wreak havoc on prices and make 2012 one of the most volatile years for energy in recent history. In this instalment, we will focus primarily on Iran – although like most things in our globalized world, there are some deep connections between what might transpire in Iran and what is currently transpiring in Europe.

Iran

In response to an embargo promoted by the U.S. and its allies, Iran has threatened to block the Strait of Hormuz, a critical shipping channel between the Persian Gulf and the Indian Ocean where 25% of the world’s crude is exported every day. Hundreds of millions of barrels of crude oil and refined products such as gasoline from Kuwait, Iraq, Saudi Arabia, the United Arab Emirates, Qatar, Bahrain and Iran (in other words, most of OPEC) all pass through the Strait of Hormuz every year on their way to major consumers in the West and Asia.

The U.S. military has admitted that Iran has the naval capability to mount an effective blockade of any maritime traffic going in or out of the Persian Gulf. If (or some would say, when) Iran actually blocks the Strait, experts such as Fadel Gheit of Oppenheimer & Co and Simon Wardell of IHS CERA estimate that we could easily see a spike to at least $150 per barrel of oil, and possibly go as high as $200 or $250 per barrel of oil. Indeed, other experts have made cases for oil going up to $300 and $400 per barrel. These higher forecasts are based on historical precedent: during the Yom Kippur War, when 6 Persian Gulf exporters imposed their own embargo on the West and other Israel allies, prices almost quadrupled between October 1973 and April 1974, from around $3.65 to near $12 per barrel (how quaint do those prices seem today?).

This scenario seems scary—until you dig a bit deeper. How likely is it that Iran will block the Strait of Hormuz, and more importantly, if they do, how successful will that blockade be? The probability of the former is admittedly higher than it has ever been, but far from certain. Iran has made several threats to block the Strait in the past. This time it seems more likely to happen because the U.S. and others are actually engaging countries in Europe and Asia with plans to impose an oil export embargo on Iran.

However, the likelihood of a full, immediate embargo is lower than headlines would suggest. A drawn out process would soften the economic blow to Iran which has had chronic economic problems for the better part of the last 15 years. The disruptive effects of the embargo on several major importers such as Italy, Spain, Greece and India, who often rely on Iran for between 8% and 15% of their oil imports, could be severe, as they would need to secure supply from other sources at a premium to their existing contracts with Iran—who also provide very generous credit terms, especially to the PIIGS.

Bloomberg reported on Thursday, January 11, 2012 that embargo talks in Europe are already stalling around disagreements on whether existing supply contracts would be exempt, the length of the transitional phase-in period, and other details. ENI, the Italian state-controlled energy company, is among one of the companies pushing for an exemption to the rule as they rely on Iran for 13% of their crude on favourable credit terms, according to Bloomberg.

Currently Europe imports around 450,000 barrels per day of Iranian crude, according to Bloomberg. One of the great ironies of this story is that more than two thousand years after Xerxes, the Persian emperor, tried to conquer the city states of Greece, the Greeks are now heavily reliant on Iranian crude for their energy needs, as they are the only producers willing to extend credit to the borderline-insolvent nation. Seems like Xerxes scored a win, two thousand years later.

In fact, sabre-rattling Iranian proclamations on the blockade may have been made partly because they knew that a full embargo was actually very unlikely, or at the least very difficult and time-intensive to implement—it will take weeks, if not months for current importers of Iranian crudes to lock down supply from other sources, and even more time for those cargoes to be delivered, much less for existing contracts with Iran to come to term. This would then allow Iran to claim an ostensible political and diplomatic victory, saving face domestically, where they face a number of mounting political and economic pressures.

This last point brings us to our next question: How likely is it that an Iranian naval blockade would be successful?

To put it colloquially, a blockade would be a total fail.

The U.S. Fifth Fleet is permanently based in Bahrain, with three aircraft carriers among the 20 heavily armed ships. Additionally, another US aircraft carrier is positioned in the Arabian Sea, with two more set to join it. Lastly, a number of other countries with aircraft carriers have sent their ships to the Gulf, including Canada, the United Kingdom, and Russia, all with the intention of showing force and solidarity. Additionally, the United Arab Emirates and Saudi Arabian forces have been stockpiling arms and buying fighter jets and other military air vehicles in preparation for this scenario for years. It is very unlikely that they will stand idly by while Iran blocks their exports. While the Iranian Navy is formidable, the combined firepower of the U.S. Fleet alone would be enough to decisively end a blockade within a matter of 2 days.

The current regime in Iran has already faced very stiff political and social opposition in the past 4 years, with unemployment and inflation at historical highs and widespread dissatisfaction in many segments of the population. A military defeat would be the blow that would conclusively undermine the credibility of the regime, and could lead to an uprising of the sort witnessed in Libya. In fact, the likelihood that the U.S. engages Iran in traditional military conflict is unlikely, although it cannot be dismissed entirely.

A more probable scenario is that they continue to build up the threat of overwhelming force in the region, while a covert program of destabilization and targeted assassinations of scientists and other critical staff in the Iranian nuclear program ensue from parties unknown, much like what happened a week past. If a blockade occurs, and a subsequent insurgency breaks out, they will probably provide the kind of aerial cover and logistical support to the insurgents that they provided in Libya in 2011.

But we digress. The blockade may spike oil prices, which in turn will lift all products in the energy complex: gasoline, diesel, natural gas and coal. What will keep prices high would be a protracted “internal” military conflict with heavy foreign support, which is our base case military scenario, or an out and out war, which is less likely but within the realm of possibility. In the internal conflict scenario, after a spike well north of $150, prices may settle in a $120 to $140 per barrel range. In a protracted conflict scenario, they are likely to stay in the $160 to $180 range.

Both scenarios, along with the associated supply shocks – most crude leaving the Gulf will experience routine disruptions in either scenario – would cause a severe recession in Europe, and milder recessions in the developed world. Brazil, Australia, Indonesia and countries in Africa are likely to outperform as they will have to pick up the slack left by the disappearance of large parts of Gulf energy supply, especially to Asia. U.S. domestic oil and gas producing equities are also very likely to outperform as they too will seek to expand their exports, as well as picking up the slack for the already-diminishing U.S. imports from the Gulf.

Ultimately, the prospect of military conflict and supply shocks will provide a solid floor for crude oil prices especially for most of 2012. However if tensions decelerate, markets will immediately focus on the downside impact that Europe is likely to have on energy demand, sending prices plummeting south. We will explore the impact of the European situation in our next article.

Feel free to write to me at michael.cooper@nullfirstlinesecurities.com if you want to share your thoughts on the role of Iran in 2012’s oil prices. Or better yet, share it with all of us at the Firstline blog: www.firstlinesecurities.com/blog particularly if you disagree. We like a good dust-up.
But we always part friends. This allows us to still offer you the opportunity to make low risk investments in the local energy sector where you can earn 6.50% on a one year tenor.
Send me an email or give the office a call at 628-1175.

Michael J. Cooper
Trading & Strategy Consultant

3 Responses to “The Weekly Report: Energy & Iran in 2012”

  1. Senyela says:

    I must say that your report made excellent reading. Your arguments about the volatility in the oil price seems to centre around the environments of the Middle East, Europe and the USA in particular. You have alluded to the show of solidarity by countries such as Russia, UK and China and you have also indicated a probable outperforming for Brazil, the African territories etc.

    Assuming a successful embargo and retaliation by Iran, can the supply of oil ( or lack thereof) by countries such as Norway, Brazil, Norway, Nigeria etc, collectively influence the oil price to still achieve a level way below $300

    How do you see developments in other parts of the world, such as the Canadian Keystone XL Project also influencing the oil price?

  2. Senyela says:

    What kind of impact/influence, if any will the constant turmoil in the middle east influence energy investors in E&P, to look to a country such as ours for joint venture and other individual arrangements?

    How do you see that possibility further developing the services sector of the industry, which forms the base for your FONL product?

  3. Michael Cooper says:

    Hi Senyela, thanks for the comments and compliments.

    As far as supply, it is a tricky situation. We know that supply plays a role in pricing but speculators/traders can also play a big role. Ultimately, a blockage of Hormuz (and subsequent naval conflict after the blockage) will affect not only Iranian exports but also major producers such as Kuwait, the UAE, Saudi Arabia, Qatar, and Iraq. While the likes of Norway and Russia are large scale suppliers, it would take a while to mobilize that crude to buyers, and it is likely that they won’t do the buyers too many favors in terms of price. This is why despite all these proclamations of embargo from Europe and Japan, when you look at the fine print there are many provisions for transitional periods etc.

    While things are getting hotter, so to speak, we are still very much in the ‘shell game’ phase of the conflict.

    As far as the impact on energy investment in Trinidad, it is also hard to say. If prices spike up and remain above 120, which seems the likely scenario if the conflict with Iran escalates, it will certainly make many of the mature fields in Trinidad more attractive, along with the deepwater areas–and heavy oil, of which T&T has reserves in hundreds of millions if not over a billion barrels.

    The services sector already appears to be on quite a solid trajectory in 2012, esp where upstream is concerned, which bodes well for FONL. However the returns on energy investment in T&T may be lower when compared with many other jurisdictions (ie Peru, Colombia).

    Fiscal terms are partially to blame, but also the size of discoveries and existing fields is relatively small. For example, ENI discovered a single field offshore Mozambique that has 25 tcf of gas. The majors who arent already in Trinidad have little incentive to come here when there are mammoth fields like that in Africa and Brazil, not to mention shale plays in the US, Poland, Argentina, and even China. I think many of the relatively smaller companies, especially Canadian-listed, would be very keen to come to Trinidad because of the political safety/stability factor, and they would probably be more likely to hire local services firms.