I’m off to the annual meetings of the World Bank and IMF this week, a good chance to take the pulse on global market consensus and the worries of policy makers. Global trade risks and their impact on an already decelerating global economy are likely to top the worry list – with the impact of tariffs, policy uncertainty on value chains in focus along with questions of policy and macro divergence, all of which have left many less optimistic than in the spring. Given the recent escalation of U.S. – China trade tensions, and signs of slackening in global export growth, the focus is likely to be on the downside risks to global growth, the divergence between U.S. economic activity and that of most of rest of the world.
Last week, OPEC+ ministers managed to come to a consensus after days of contentious discussions in Vienna, achieving the goal of formally keeping the OPEC+ alliance together, but failing to solve some of the thorny issues between key members including Saudi Arabia and Iran. The final agreement, which commits the group to reversing recent overcompliance to boost production, remains formally agnostic on who will contribute to that production increase. This post looks at the factors that will shape upcoming fundamental outlook and assesses the macro impact for some key producers.
This suggests the alliance has moved into a transition phase of exit and shift to a different and more contested data dependent mode. The time-buying (or can-kicking) deal allows for more time to assess several key supply and demand variables described below including the impact of sanctions, the politically driven pressures and the resilience of global consumers.
In the near-term, the results support higher prices, especially as the net addition of fuel will be modest, and the result of individual decisions not the collective. Meanwhile the looming implementation of Iran sanctions poses a risk. Additions from the countries which can add will likely to offset by continued Iranian export declines as businesses trim their imports ahead of key November sanctions dates. The uncertainty around supply and risk of unilateral action to make up the gap. increases the likelihood of volatility and production.
Overall the result mapped with my expectations of gradualism, a moderate increase now, with ongoing reassessment and eventual gains through the year. As noted in our coverage of the Iran deal exit, OPEC members were likely to add supplies slower and more modestly than some market actors expected, while bargaining and price discounting from the Iranians would complicate assessment of production. The political pressures and uncertainty on production outlook in several key countries (including Venezuela, Iran, Libya, Nigeria), make it hard to imagine a different outcome, but divides will build over time, as further outages build in countries like Iran and Venezuela and only a few countries can produce more in compensation.
Focus on the big alliance, not only the smaller ones within OPEC: The result highlights the importance for Saudi Arabia (and GCC allies) as well as Russia of retaining the alliance struck in 2016 on managing oil output. Remaining vague on the details of how the production will be re-allocated from Venezuela to the countries with spare capacity, avoids a political decision that will eventually need to be addressed, since its hard to see any meaningful increases from that country. In fact, output is likely to fall further due to strikes, job cuts and equipment seizures.
Gradualism allows for more information gathering: By later in the fall, there should be more clarity on the following relevant fundamental issues that make it currently difficult to plan.
Exit from easing needs new forward guidance. 2018 was always going to be the year when the alliance shifted to a new phase. Like global central banks moving to quantitative tightening, the alliance (which was in a formal tightening phase), will employ new forward guidance for easing. The Joint monitoring committee (and a range of private monitoring bodies, are likely to take on a bigger role with focus moving beyond 5 year inventories as their main fundamental metric. It remains unclear what the new metrics, and forward guidance will look like. Saudi Arabian officials have already gone on the record to highlight the need for well over 1 million barrels a day in increase by the end of the year. Doing so, while absorbing Iranian output is likely to be difficult.
What might the impacts be on oil producers?
The decision brings increased breathing space to most oil producers, especially Saudi Arabia, most of the rest of the GCC and Russia, which account for the bulk of global spare capacity. While prices might soften from their recent levels, the increase in output, even if moderate should keep oil revenues elevated compared to 2017 levels and increase the energy contribution to growth. This should modestly reduce oil fiscal breakevens, though we assume that most countries will take the opportunity to spend a little more given that non-oil growth has been sluggish especially in MENA and SSA.
Our analysis suggests more GCC countries will use this space to become a little more expansive on the fiscal side, offsetting for what continues to be sluggish private sector growth, credit and sentiment. We have already seen stimulus rolled out in Abu Dhabi and Qatar, and spending outpace plans in Saudi Arabia, though some of these look temporary. We assume that fiscal breakeven price in Saudi Arabia may fall slightly to the low/mid 80s from the current $89/barrel, suggesting slightly less draw on debt. This implies that there will be more final demand rather than petrodollar savings. Countries in a position to save more include UAE (Abu Dhabi), Kuwait, Qatar, Russia, Kazakhstan, and possibly Nigeria. The chart below highlights likely shift in the current account surplus (flow of savings net of imports of goods and capital).
Other countries including Oman, Saudi Arabia, Iraq will likely tend to borrow less or draw down fewer reserves. Saudi Arabia likely will have more pump priming space to support the private sector.
We see a modest increase in Russian output, but limited impact on growth. In Russia, the flexibility of the exchange rate remains a key adjustment tool and increase in output is an offset to the financial cost of sanctions.
Those most vulnerable remain Venezuela, where local mismanagement, asset seizures and the exacerbating impact of sanctions suggest significant further outages. While politically OPEC could not formally reallocate its target, its hard to see any reversal of outages, especially as recent legal cases and strikes undermine its capacity further.
Iran, too will start to feel the pinch from the drop in oil prices, with the full impact dependent on sanctions implementation. For more on the scenarios, please see here. Decisions on adjusting to Iranian outages are more likely to be bilateral (between buyers and sellers) than within the alliance, but its hard to see if able to sell its current targets.
Last week, I wrote about some of the key questions surrounding the U.S. withdrawal or rather violation of the JCPOA which focused on the responses of Iran (production, discounting, regional policy), Europe (blocking measures), and Asian buyers of Iranian goods. Since then the focus has been on the European counter response to the U.S. decision, and on assessing the energy market impact, and the potential risks to the use of sanctions as a policy tool. I provide a few follow up thoughts here.
Exit first, protection later: Many European companies seem to be preparing to freeze or reduce their investment, worried about the risks of future fines, despite pledges of blocking statutes. Developed markets in Asia are likely to be more cautious Meanwhile at the same time, European leaders are rushing to implement blocking legislation that would shield European companies from fines, and would forbid some companies (banks?) from implementing measures lest they face other fines. These measures have exposed divergent views between and within key European countries (notably France and Germany in recent days).
The blocking statute and other moves are in part one of principle in which the Europeans look to establish their concern about U.S. extraterritorial sanctions for the current and future cases, especially where U.S. and Europe have diverging views on the goals. Companies may choose to be cautious implementing cuts or freezing new deals given their concerns about the limited upside from trade in this environment, and fearing to loose access to U.S. markets. The net result is likely one of confusion, broader derisking as some companies scaling back activity won’t scale it back up without assurances from Iran. As others have noted, the imposition of sanctions may be the nail in the coffin for investments that were already on edge due to questions about the investment terms including some oil and natural gas contracts.
Oil: Oil volumes will be a major indicator for all to assess whether the process of undermining or stabilizing the deal is a success. The Trump administration is likely to look for reductions to show that sanctions are being implemented, while Iran would likely see volume drops as a sign of bad faith from trading partners, leaving European and Asian buyers in the middle. One key difference from 2012 is that EU member states quickly eliminated oil imports, leaving key Asian buyers and Turkey to take part in the “significant reductions” in imports. Europe is unlikely to do so this time given the political goals. Expect there to be greater uncertainty and debate around the metrics to use in tracking compliance. As noted, last week, OPEC+ may well act slower and less extensively than buyers hope, increasing price spikes and overall volatility.
The chart below highlights some of the countries that will be pressured to reduce imports. While it includes non-oil exports as well as fuel, it provides a useful breakdown. One thing that stands out is that Iranian exports to Europe and India experienced the greatest boost post-JCPOA, with volumes increasing more modestly to South Korea, Turkey and China, as these countries tried to balance their regional trade. Japan notably, barely increased trade from the pre-JCPOA levels (though the change in energy prices partly obscures the trend.
Iran exports have been increasing along with hydrocarbon prices (rolling 3 month sums, USD billion)
Source: IMF (via macrobond)
The OFAC guidelines suggest waivers would only be granted to those companies that show “significant” reductions in the coming months ahead of the November deadlines. Market analysts estimate export declines of 200-700 thousand barrels in the coming months, and more in 2019, quite a wide range in scope. complicating this, the definition of significant reductions is less than clear as the Trump administration hasn’t signaled whether they share the Obama administration definition of 10-20% declines over each six month period, or how they consider market price dynamics. Given the timing of decisions may continue to boost oil prices in the summer and fall as the mid-terms approach, these signals could be very important.
This suggests that companies looking to play it safe may reduce volumes, especially if the Iranians are unwilling to discount as Chinese and Indian buyers are likely asking for. Those countries that have already negotiated insurance or set up vehicles to do so in 2012-14 may be better positioned to maintain their market share or engage in barter agreements with Iran. Many Asian countries had to learn quickly to navigate the system to make sure their payments reached the Iranians in that period. European insurers or banks are likely to be much more worried than some of their EM Asian counterparts. This suggests that Chinese, Indian and Russian influence may increase.
Shares of Iranian Exports by Countries (% of total exports in USD terms)
Source: IMF (via Macrobond)
Impact on OPEC+ agreement: Many analysts see the sanctions decision as a risk to the OPEC+ (Vienna group) agreement which seeks to restrict output. Its definitely a test, and one likely to tighten the market further, particularly coming after massive declines from Venezuela and more moderate ones from Nigeria. The former’s almost 1mbd decline was partly absorbed by other countries cheating, but still resulted in quicker rebalancing of the market. In Iran’s case, other countries, most likely GCC countries like Saudi Arabia might respond by just directly selling more, rather than formally changing the deal. Recent statements from OPEC+ members don’t seem consistent with a group ready to start adding a lot more capacity – adding to uncertainty and the risk that new suppliers are slow and lower volumes than expected.
The ongoing trade threats and negotiations likely complicate oil decisions, amplifying the incentive for some actors to maintain their imports, and reducing it for others. Japanese and Korean companies, mostly government owned, may have high incentives to temper purchases to avoid fines, and perhaps to avoid retaliation in other ongoing trade negotiations and the planned DPRK discussions. Similarly, divergence in interests between European countries (Germany and France) may reflect ongoing negotiations on planned tariff implementation as well as the spillovers from Russia sanctions, not to mention different views on industrial policy (government support of companies) as well as the divergent sectors of interest in Iran. The net result is likely to be one in which China, already a dominant player in Iran (as a supplier, buyer and investor) increases its involvement. Meanwhile Russian interests could also increase, though its increased reliance on China and GCC as a source of long-term investment could muddy the waters there.
Impact on Iran’s economy: Many analysts believe that export declines might outpace that of production as Iran might seek to fill its relatively empty floating storage and might look to refine more products in the hopes of selling. While Iran might initially look to use a loophole and continue exporting products, such a loophole is unlikely to exist for long.
The overall impact on Iran’s economy is likely to be painful, especially coming in the midst of the ongoing currency crisis. A lag between production and export declines would shift the impact on Iran’s economy as oil sector contribution to GDP might slow more gradually (if at all) in the near term as output remains steady. However a reduction in sales would hit revenues and liquidity and likely constrain domestic demand via reduced government spending and lower domestic liquidity. FX shortages might reinforce these trends especially if the central bank continues its tight policy to temper inflation. Eventually, both exports and production might fall, hitting both oil and non-oil growth, as higher oil prices don’t offset for the volume losses. The concurrent reduction in (albeit limited) long-term investment would add to the drag, suggesting Iran’s growth could slow or even move towards recession.
Related imports (either for auto manufacture), energy projects or broader infrastructure are also likely to slow, especially if Iran struggles to make payments. This implies that Iran may become even more of a price taker on its imports, relying more on countries that buy its fuel. The full “escrow” account system that was much criticized in 2012-5 (it allowed for accrual of funds in local currency within oil consuming nations to purchase only approved goods), is unlikely to resume in the same degree, with financial transactions more leaky than at that point. Still, key consumers of fuel are likely to be direct or indirect suppliers, even as overall imports and the ability to pay for them declines.
Imports have been trending up, especially from Europe and UAE (rolling 3 month sums, USD billion)
Source: IMF (via macrobond)
Early last week I wrote about my concern that the risks Iran deal were not on the radar of many global investors and policy makers, one of the surprises from my last DC trip. I needn’t have worried – its now top of the agenda, or at least sharing it with China trade, Nafta and DPRK - a very busy agenda. If the U.S. were a Muslim country, I would be accusing policymakers of trying to get things done before Ramadan begins, but election timelines and a desire for continual pressure on negotiating partners seem to be a more realistic explanation.
With the Iran deal front of mind seems a good time to expand on a few points from my ongoing analysis of Iran’s economy, including what’s happened since the passage of the JCPOA. While the economy has had some breathing space, focused around the revival of the energy sector, local policy choices and limited foreign investment kept domestic demand weak and challenged any private sector credit revival, all trends that are likely to be even more complicated in the coming months.
With OPEC members and friends (and the ever growing energy journalist cohort) meeting in Vienna, it seems apt to look at the economic adjustment of some of the participating oil producers. While most would gain from rising prices. Russia, and Iran, smaller GCC countries (Kuwait, UAE and even Qatar) as well as some U.S. producers would look to be the relative winners. The slowbleed of capital outflows, external and fiscal deficits are likely to moderate across most of the other producers including Saudi Arabia, Oman, let along more vulnerable countries like Nigeria, Angola which are still struggling with the aftermath of their FX policies. With U.S. and global interest rates edging up, expect continued rate and sovereign risk divergence.
Rachel's musings on macroeconomic issues, policy and more.