The Impact of Iran Sanctions Six Months In

Over the coming week, Western sanctions on Iranian oil exports formally take effect. Starting tomorrow, any bank processing payment for Iranian crude trade received an exception, and as of Sunday, shipping insurance providers will lose their European-based reinsurance if they continue to cover Iranian oil cargos. This note provides a wrap-up of the oil market impacts of sanctions to date and an outlook for the months ahead.

Better than expected compliance:  Iranian crude oil exports fell to 1.6 million barrels per day in April (the last month for which complete data is available), down from 2.3 million bpd in the year prior. This is a steeper and quicker drop than most analysts expected at the start of the year. While Chinese imports rebounded in May and are likely to hold steady in June as well, overall Iranian exports will still be at, or slightly below, 1.6 million barrels per day at the end of the second half.

Iranian revenue has already taken a hit:  Even though sanctions on Iranian oil exports haven’t formally taken effect, the combination of reduced purchases by Iran’s customers in advance of the deadline and falling oil prices have already significantly reduced Tehran’s oil revenue. Assuming the Iranians are getting paid at market price and in a timely manner (both big ifs), monthly oil revenue was down 33% year-on-year in April and is set for a 50% decline in June.

And things get tougher for Tehran in the months ahead:  Provided the oil market stays soft, the hole in Iranian export revenue will grow during the second half of the year. European imports will cease entirely. South Korea and small exporters like Taiwan and Sri Lanka could stop importing entirely thanks to the EU insurance ban. And India, Japan and Turkey may need to keep cutting depending on how the Obama Administration interprets the sanctions legislation.

Sanctions Compliance Better than Expected

When fresh sanctions on Iran were signed into law by President Obama at the end of last year, many oil market observers were skeptical it would be a big enough stick to convince Tehran’s customers to wean off Iranian crude. Given how tight the oil market was in the first quarter, analysts speculated that other countries would balk – afraid of the impact on global oil prices – or that the White House would take advantage of an escape clause included in the legislation should sanctions implementation leave the market short of crude supply.

Tomorrow is the day sanctions officially start to bite. Any bank caught processing payment for Iranian crude exports will be vulnerable unless the bank’s country of primary jurisdiction has secured an exception or waiver from the State Department. And next week European refiners will be barred from importing Iranian crude and European insurers will be prohibited from covering Iranian crude shipments, a move that impacts 95% of the global reinsurance market.

Based on partner trade data, compliance with Western sanctions has been far better than expected. Tehran’s customers imported 1.6 million barrels of Iranian crude per day (bpd) in April (the last month for which complete customs data is available), down from 2.3 – 2.4 million bpd in 2011. Tanker tracking services report similar numbers. This is at the upper end of our 650,000 – 775,000 bpd estimate from February (see “Iranian Oil Sanctions and the Meaning of the Word  ‘Significant’”, February 29, 2012). Europe made the steepest cuts as refiners prepared for the July 1 ban (Figures 1 and 2), followed by China and Japan. Japan’s reductions were policy-based while China’s resulted from a price dispute between Sinopec and NIOC. Chinese imports recovered in May but were offset by further European and Korean declines. Indian refiners snatched up some of the cargos Sinopec didn’t buy, which pushed up their Jan-Apr average (Figure 2). But by March New Delhi had told the country’s refineries to start weaning off and Indian imports turned the other direction. April and May were down 40% and 38% year-on-year, respectively.

Iranian Revenue Takes A Hit

Increased Saudi production and global economic weakness have managed to soften global oil prices despite the loss of 700,000-800,000 bpd of Iranian supply, dealing a second blow to Iranian revenue. If the National Iranian Oil Company (NIOC) was paid its official selling price (OSP) for every barrel exported in April and was paid in a timely manner, Tehran earned $5.6 billion in monthly oil revenue, down from $8.4 billion in April 2011 (Figure 3). If exports remain at 1.6 million bpd through June, maximum monthly revenue will decline to $4.3 billion, a nearly 50% year-on-year decline.

It’s unlikely NIOC is getting its full asking price or being paid promptly: Iran’s customers have considerable leverage over price given the inherent political risk of doing business with Tehran, banks and shipping companies have increased transaction costs, and oil paid in Rupee or RMB through barter accounts comes with a significant implicit discount. That said, $4 billion per month is still more than Iran earned any time between 1982 and 2005, so the question for policymakers (and one I certainly don’t have an answer to) is whether it’s enough of a reduction in light of current Iranian revenue needs and social and political dynamics to get the desired concessions from Tehran.

No Relief in Sight

As the result of the EU insurance sanctions, small Iranian importers like Taiwan and Sri Lanka, and not-so-small importers like South Korea, will likely cease purchasing Iranian crude all together after the July 1 deadline. With no sales to Europe overall Iranian exports will decline to 1.2-1.3 million barrels per day in the second half if Japan, China, India and Turkey maintain imports at current levels. Japan, India and Turkey could well cut further, particularly if the State Department interprets sanctions legislation as defining the “significant reductions” required for an exception as relative to the preceding 180 day period (half-on-half) rather than the same period in the previous year (year-on-year).

That leaves China as Tehran’s only hope for defending current export volumes. While tanker data suggests China’s June imports will be meaningfully higher than the 525,000 bpd imported in May, Chinese refiners to stick pretty close to 2012 term-contracted quantities (500-550,000 bpd) on average as long as the oil market stays relatively loose. In weighing the commercial benefits to Chinese trading houses of buying discounted Iranian spot cargos against the diplomatic costs of significantly increasing purchases from Iran, I’d expect Beijing to tell Chinese refiners to keep import quantities stable. Should the market tighten, Beijing’s refusal to buy distressed Iranian spot cargos will have a more significant impact on global prices, in which case the cost-benefit analysis would change. But given the price Chinese traders would likely pay for those barrels, it wouldn’t necessarily provide that much revenue relief for Tehran.