8 May 2018

What happens to oil if Trump tears up the Iran deal?

By Suhaib Kebhaj and Joseph Hammond

For all Boris Johnson’s best efforts to persuade him otherwise, President Trump seems likely to pull the United States out of the 2015 Iranian nuclear agreement, formally known as the Joint Comprehensive Plan of Action (JCPOA).

This weekend Rudy Giuliani symbolically ripped up a copy of the JCPOA when speaking to a conference of the Iranian opposition in Washington D.C.

The former New York mayor is now part of President Trump’s legal team and his views are shared by many in the White House, including National Security Adviser John Bolton and other Iran hawks like Secretary of State Mike Pompeo and Secretary of Defense James Mattis.

Tearing up the deal would mean the resumption of the sanctions first imposed in 2012, and severely limit oil production from the third largest oil-producing country in OPEC.

The impact on the oil industry would be huge. Were sanctions to resume it could mean somewhere between 300,000-500,000 fewer barrels of crude oil per day by the fourth quarter of this year.

A study published in Energy Economics in 2016 offers the rosiest picture of what could happen if large amounts of oil were to disappear. It noted that generally when Iranian oil production is withheld from the global market it does not result in a long-term price increase. Saudi Arabia usually rebalances the market by increasing its production to cover the lost Iranian supply.

This time, however, the Saudis might not increase production. In fact, some studies suggest that given the Kingdom’s high spending and low tax revenues, the Saudi government needs the oil price to rise to around $90 a barrel to avoid running a deficit.

OPEC countries along with other oil exporters, namely Russia, have also committed to reducing production till the end of 2018 in order to draw down reserves and rebalance the oil market. This will likely be extended through to 2019 when the topic is discussed at June’s OPEC meeting.

Meanwhile Venezuela, Iraq and Libya remain wild-cards as all three countries want to increase exports but have to contend with a high-risk security situation. Given these factors we could see oil prices well above $70 a barrel in the near future.

The news of jumps in the price has enraged President Trump, who took to Twitter last month to lash out at “artificially high prices”.

But low-income countries reliant on commodity exports may be quietly applauding.

With oil prices climbing other commodities will likely climb as well. To some extent metals, oils and other commodities are benefiting from strong synchronised global growth across emerging and developed markets.

There isn’t much spare capacity for increasing production as the collapse of commodity prices following the last cycle led to a drop-off in long-term investment. This is affecting commodity supply chains, in an environment of strong global growth and increasing demand. OPEC production cuts and a decline in Iranian oil exports would only worsen this problem.

There could also be knock-on effects on agriculture as a hike in the oil price results in increased demand for biofuels. As biofuels become more profitable farmers might opt to produce maize or other plants, in turn reducing the supply of fruit and vegetable crops and potentially pushing up food prices.

Since the early 2000s commodity markets have experienced a higher degree of financialisation, resulting in increased co-movement in prices, usually led by movements in the oil price due to its high weight in the commodity financial market. So we could expect to see increased commodity prices across the board this time as well.

This is good news for many commodity exporting countries who will be able to enjoy higher windfalls. It’s especially good news for poor countries who have taken a severe hit from the drop in commodity prices in 2014 and the current period of cheap oil.

Many of these countries have run up dangerously high deficits as a result of lower commodity prices in recent years, with some at risk of default. Masood Ahmed,  who heads the Center for Global Development, has warned of a looming debt crisis in low-income countries.

For those countries the prospect of a Trump-inspired increase in global commodity prices could be the saving grace that allows them to avoid default and maintain their current spending levels.

Suhaib Kebhaj is a research analyst at the International Monetary Fund. Joseph Hammond is a fellow of the Center for Media and Peace Initiatives.