A special message from Joyce Chang, Global Head of Research
In this edition of Geopolitical Flashpoints, which can also be found on J.P. Morgan Markets, the Global Research teams examine the economic and market implications of the re-imposition of Iran sanctions on November 5 as the Trump administration deadline to unilaterally withdraw from the 2015 Joint Comprehensive Plan of Action (JCPOA) nears on November 4. The reports highlighted below summarize the latest developments and include recommendations and views across asset classes.
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As the November 4 deadline that President Trump set to unilaterally withdraw from the 2015 Joint Comprehensive Plan of Action (JCPOA) and the re-imposition of sanctions on November 5 looms, we assess the macro and market implications. The basic aim of US secondary sanctions is to force non-US companies to choose between transacting with the US and its financial system, or with Iran. Ending the Iran deal was a key foreign policy plank of candidate Trump’s election platform and the effects of the sanctions are already becoming evident. The latest Iranian export data suggests that many countries that import Iranian oil have already started to reduce their imports significantly well ahead of the November 4 deadline. While there is still uncertainty around how much Iranian barrels would be lost once the sanctions are implemented, the markets have tried to price in anywhere between 0.5mbd (in early June) to just over 1mbd (late Sep/early October) of exports being curtailed. Iran crude exports fell to around 1.6mbd in September as major importers including China scaled back their crude purchases. We now expect Brent to average $85/bbl in 4Q18 and $83.5/bbl in 2019, with Brent to finish at around $90/bbl by year-end. The upward revision in our forecasts was strongly driven by significant supply-side risks, more than offsetting the expected softness in demand. In the absence of Iran supply concerns, oil prices would have likely hovered around or below $70/bbl, but with the presence of Iran risks we expect oil prices to remain well supported in the months ahead. Iran oil sanctions could put 1.5-2.4mbd of oil exports at risk, which would more than compensate any demand drop due to slower global growth and trade tensions. While the growth impact of US-China trade disputes matter for commodities demand, Iran matters a lot more in the case of oil, given the large supply shock it could represent in the very near term. Iran poses a first order effect via supply shock whereas US-China trade war poses a second order effect via economic growth slowdown.
Background on US sanctions on Iran and decision to re-impose sanctions
Since the late-1980s, a series of sanctions have been imposed against Iran, including by the United States, the European Union and members of the United Nations (UN) Security Council, due to Iran’s refusal to suspend the enrichment of uranium and other activities deemed malign by participating members. As a result of sanctions, Iranian inflation topped 40%oya, while oil exports and growth collapsed after 2012. After 20 months of talks, in July 2015, the Joint Comprehensive Plan of Action (JCPOA) was agreed between the 5 permanent Security Council members, Germany and the European Union with Iran, to limit the country’s nuclear program in return for lifting the European Union and United Nations nuclear-related sanctions and US secondary sanctions, although US comprehensive primary sanctions preventing US individuals and companies from engaging with Iran remained in place.
On May 8, President Trump announced that the US would unilaterally withdraw from JCPOA and reimpose all sanctions lifted or waived in connection with JCPOA after wind-down periods of 90 or 180 days. As President, Trump had signed waivers in 2017, but finally made a
May 2018 announcement regarding his intention to quit the JCPOA, blaming Iran’s ballistic missile tests and actions across the MENA region as justification for the US to pull out from “the decaying and rotten deal”. The re-imposition of so-called “secondary sanctions” aimed at non-US companies’ dealing with Iran began after the wind-down periods; the first set of secondary sanctions became effective on August 7, which reimposed sanctions to include purchase or acquisition of US dollar banknotes by Iran, trading in commodities such as gold, steel, coal, semi-finished metals, such as aluminum, and some other transactions related to commodities, currencies and sovereign debt. The next set of sanctions—which target the oil trade—come into effect on November 5. The sanctions to be reimposed to include those targeting Iran’s port operation, shipping sector, and most importantly, transactions with the National Iranian Oil Company (NIOC), Naftiran Intertrade Company (NICO), and National Iranian Tanker Company (NITC), amongst others. In addition, sanctions on provision of underwriting services, insurance or re-insurance and transactions by foreign financial institutions with the Central Bank of Iran and designated Iranian financial institutions under Section 1245. The transfer of payments may be impacted if the SWIFT network is disconnected as in 2012. In addition to these sanctions, the US government will reimpose, as appropriate, the sanctions on persons removed from the Specially Designated Nationals (SDN) list. President Trump’s executive orders would not only turn the clock back to the sanctions regime that prevailed before the JCPOA—critically, on a bilateral basis, compared to the multilateral framework that prevailed before—but they may want to go even further. The sanctions can effectively cutoff access to the US financial sector not only for any party dealing directly with Iran, but also third parties (including international banks, insurance companies, shipping companies) facilitating significant transactions with Iran.
Additionally, on October 3rd, the US Secretary of State terminated the Iran Amity signed in 1955 after Iran used it as a basis for a case at the International Court of Justice. The Amity Treaty, an agreement to encourage good relations and trade, was signed with the Iranian Shah, who was a US ally. Although an insignificant act in itself, it does point toward a more hawkish stance on Iran.
Oil Commodities Research View
Global oil supply should tighten after the imposition of Iran sanctions, with risks biased to the upside especially after US mid-term elections. The upward revision in our forecasts has been driven by significant supply-side risks as importers of Iranian crude have scaled back significantly in the run-up to the November 4 deadline. This has been one of the key drivers of oil prices in 2018. Front month Brent has risen by as much as $20/bbl since the start of the year until recently when it touched $86.3/bbl on Oct 03. There is still uncertainty around how much Iranian barrels would be lost once the sanctions are implemented and we estimate the markets have tried to price in anywhere between 0.5mbd (in early June) to around 1.5mbd (late Sep/early October) of exports being curtailed. Iran exports close to 2.5mbd of its crude output with the remainder consumed domestically. In a briefing published by the US State Department in June, it was suggested that oil imports from Iran should be cut down to zero. Whilst there have been several comments earlier this year by the State Department that reflected no predisposition towards waivers, this position has changed to a case-by-case basis waivers for countries that are making efforts to reduce their imports. Despite the levels of waivers remaining unclear and uncertain in the near-term, we do expect the US administration to push these countries to significantly reduce their imports from Iran eventually even if they were to receive some waivers initially to allow them to replace Iranian crude supply.
The latest Iranian export data suggests that many countries that import Iranian oil have already started to reduce their imports significantly well ahead of the November 4 deadline. Iran crude exports fell to around 1.6mbd in September as major importers including China scaled back their crude purchases. Additionally, buyers of Iranian oil have indicated their reluctance to buy Iranian oil to avoid any repercussions given the uncertainty. Currently the market is not short oil as Iranian oil is still in the market and Saudi Arabia and Russia have ramped up oil production to avoid a spike that concerned some of its key consumers and allies. However, the risk of losing another 0.5mbd to even 1.5mbd (from current ~1.5mbd) in a worst case scenario where US pushes towards it zero Iran export target could tighten the oil markets significantly in the near-future and OPEC’s spare capacity could be challenged even in a modest oil demand growth environment. The retaliation from Iran to return to full-scale Uranium enrichment or block Strait of Hormuz could be seen as a major geo-political risk to oil but also the region that is currently steeped in various conflicts.
Oil markets are currently very fragile and anxious as the very drivers, such as strong demand and tight OPEC supply that helped balanced the markets earlier this year, have started to raise uncertainty around the recovery in oil price. Despite the weakness in physical markets due to the factors mentioned above, we think the impact on the oil markets from the loss of Iranian barrels will only be felt once physical markets show signs of tightness post re-imposition of sanctions on November 5. Once the physical markets show signs of tightness, then the lack of spare capacity and rising geo-political risks surrounding oil producing countries including Iran, Venezuela, Russia and Saudi Arabia should be sufficient in returning robust support under oil prices once again. We don’t doubt that the Kingdom can increase production towards its 12 mbd capacity; however, the timing of it is what markets will question once Iran’s sanctions are in force and start to tighten physical markets and markets for medium/heavy sour crude. Most of the Kingdom’s available nameplate capacity remains constrained. At 10.7mbd of current production, their nameplate spare capacity is 1.3mbd as also suggested by the Saudi Oil minister but the real available capacity is questionable in the near term. Abhishek Deshpande
Economic and Political Views
The effect of sanctions against Iran’s economy has already become evident, with Iranian oil production declining 12% from its peak in May, as trade partners begun to reduce their oil imports. Oil prices have reacted in sympathy, as our commodities strategy has commented extensively. As a result of these developments, the Iranian rial depreciated by up to 75% in the black market through September and inflation accelerated to 31.4%oya. Against this background, a series of protests have erupted with deteriorating economic conditions throughout the year. Iran has threatened the closure of the Strait of Hormuz, through which one fifth of global oil trade passes, if the country is not permitted to export its oil. Despite Donald Trump’s offer to meet Iranian president Hassan Rouhani without preconditions, it remains unlikely that the Iranian government will return to negotiations in the near-term.
The reactions of large importers of Iranian oil, like China and India, would seem to be critical to judge the degrees of freedom enjoyed by countries that otherwise would spurn such US extraterritorial sanctions. The EU for its part has staked out a strong stance to defend its political decision to try to keep the Iran deal (JCPOA) alive, notably with the extension of the 1996 EU “
Blocking Statute” to include US Iran sanctions, which ostensibly compels European entities to not comply with extraterritorial US sanctions. However, it remains to be seen whether, in practice, the Blocking Statute will dissuade European companies from deciding to stop dealing with Iran given many firms have too much to lose if their US business / access to the US financial system becomes compromised. The more interesting European policy proposal (in conjunction with China and Russia) is that of an Special-Purpose Vehicle (SPV) to allow non-US firms to effectively deal with Iran in legitimate business (as per EU law) anonymously, and therefore, not run the risk of being targeted by the US. This proposal, which has been strongly criticized by the US, has yet to be unveiled and tested operationally. A key battleground on the US’s willingness and ability to counter this proposal would be whether the Trump administration would challenge the SPV itself or the European or other central banks supporting the SPV.
At the country level, while Turkey and India are most vulnerable through the trade channel, another perhaps even stronger impact of sanctions could come through the financial channel, as local companies and banks could be denied access to critical USD payment systems. Turkey, India, Korea and China have the highest exposure to Iran through the trade channel, with bilateral trade with Iran ranging from 0.9%-2.75% of overall trade for these economies.
Ben Ramsey, Giyas Gokkent, Nur Raisah Rasid
Cross-Asset Strategy Views
We have been long petro assets to varying degrees all year and recommend keeping such exposure while supply risks persist and Brent is below $90/bbl. We were maximum long in Q1 and Q2 (long Oil futures, overweight US Energy Equities and HY Energy Credit, and long either NOK, CAD or RUB), moderately long in Q3 (we went tactically short crude in early summer), and now close to maximum long again (re-entered long Brent in September). To be sure, the value proposition of petro assets varies considerably, with Energy Equities, Energy Credit, Russian Equities and US inflation breakevens discounting the highest oil price, and petro-currencies like RUB factoring in the lowest price. But the ruble is only interesting as an Iran hedge for those who think that higher oil prices will do more good for Russia through a higher trade surplus than further Russia-specific sanctions might harm capital flows. For now, we are neutral oil currencies given a generally strong US dollar environment, and hedge Iran supply risks through oil directly or with oil stocks and credit. John Normand
Global FX Views
The primary transmission of Iran sanctions to FX is likely to be through oil prices with our commodity strategists expecting that Brent could breach $90/bbl going into year-end. This will likely inform the performance of petro-exporters vs. importers. We have long argued that even though petro-FX has lagged oil prices, a more selective stance on these currencies is required. The performance of several petro-FX has been held back due to various idiosyncratic factors that have not translated into a growth boost for these currencies. Even though oil prices have been increasing for 2 years, our growth forecasts for petro-currencies have not increased by much.
On a more granular basis, growth in G10 countries (CAD and NOK) has fared better than EM petro FX (COP, MXN, RUB) where average growth forecasts have actually been downgraded over this same period. Among G10 petro-FX, we are structurally bullish on NOK (neutral in the recommended trade recommendations, but long NOK in the long-term recommendations) and have bullish forecasts for CAD (though for reasons other than high global oil prices, as local crude prices are in fact heavily depressed). Oil prices have impacted forecasts of RUB in recent weeks (RUB targets were upgraded by 5% over the next three quarters), but we are still neutral which is still a more favorable stance compared to other high-yielders in the region such as ZAR where we are underweight. In Latin America, we are neutral both MXN and COP as weak EM appetite and policies implemented domestically could continue to offset the terms-of-trade positives from higher oil prices.
We also assess the impact of higher oil prices on energy importers. J.P. Morgan FX forecasts for energy importers have been downgraded in recent weeks. For instance, in G10, our Japan strategists downgraded JPY in October in part motivated by deteriorating external balances related to oil. We are short JPY versus USD in our recommended macro portfolio. In EM, our strategists point to INR underperformance in part being linked to higher oil prices (where FX targets were cut in sympathy with CNY in September). In addition, higher oil prices have also had an impact on TRY weakness, but admittedly this has been a secondary driver given other idiosyncratic factors in the country. Meera Chandan, Jonathan Cavenagh, Anezka Christovova, Robert Habib, Daniel Hui
US Credit Research Views
Second order impacts on US Credit from sanctions on Iran are meaningful. Few, if any, of the companies in our combined universes are actively involved directly in Iran post the last round of sanctions. However, sanctions are likely to increase the overall risk premium and volatility of the commodity, which should filter through the ecosystem. In the near term, a greater call on US shale could have an additive effect to the services sector as activity levels increase on the back of the expectation of sustained higher prices. More importantly, increased cash flow and improved leverage metrics have particularly topical implications.
Sanctions could accelerate Rising Star pipeline. US High Yield (specifically BB) rated credit stands at a cross-road, with a substantial amount of BB-rated E&P and MLP credits poised for transition to investment grade at current strip pricing. Sanctions could easily accelerate that trend as E&Ps use excess cash flow from the “Iran bump” to pay down debt and/or achieve critical mass for investment grade ratings. Similarly, on the Investment Grade side, one of the greatest overhangs market wide on US credit is the “low-BBB wall” and potential Fallen Angel implications during the next cyclical downturn. Capital and balance sheet discipline remain front and center in Energy. Therefore, we expect BBB-rated Energy companies to continue to use excess cash flow to pay down debt and bolster balance sheets as well as start to return value to shareholders in a disciplined way.
Value continues to accrue to critical infrastructure. Finally, one important downside of sanctions impact is the potential supply demand imbalance when/if sanctions end. Midstream company bonds remain a source of “safe spread” and are somewhat insulated from the commodity. We continue to see good value in Midstream and MLPs especially in a more volatile crude oil environment. Prudent growth and deleveraging remain the focus, and in a world of wider differentials and increased volatility, value is inexorably moving within the industry food chain towards infrastructure. Tarek Hamid and Matthew Anavy
Emerging Markets Equity Strategy Research Views
Near-term upside via better support to oil prices offsetting medium-term negative geopolitical risk to EM equities could be the result of the US decision to advance on the Iranian sanctions. The near-term positive is backing to higher oil prices. There is a strong historical co-movement between GEM equities and oil price rallies and corrections. During periods of rising oil prices, the median return for GEM equities was USD20%. In 80% of the positive return periods for oil, GEM equities also posted positive returns. LatAm and CEEMEA are the most impacted by the change in oil prices and EM Asia the least. Russia, Colombia, Brazil, Thailand and Poland have the highest positive sensitivity to oil price changes. The potential medium-term negatives to EM equities could include a narrower hallway to US-EU future cooperation in other geopolitical sensitive issues such as Russia and Syria, for example, and an unintended re-escalation of nuclear investments in the Middle East region for neighbors to defend themselves from a possible Iran threat.
Overall oil strength has been more positive for GEM vs. DM equities as it is possibly associated with periods of high economic growth expectations. This is where the risk lies in the current cycle. The core reason for the upward revision in oil prices is a supply constraint and weaker global growth. We prefer to keep a Neutral rating on Energy to remain less directionally dependent on short-term volatility in oil prices. We could indirectly benefit from higher oil prices by OW positions on Russia, Brazil, and on energy in the ASEAN region.Pedro Martins and David Aserkoff
Please find below links to recently published reports from the J.P. Morgan Research team.
GLOBAL RESEARCH
EMERGING MARKETS ECONOMIC RESEARCH
Iran sanctions: On again: Bracing for the November 5 reimposition (Ben Ramsey, Giyas M Gokkent, Nur Raisah Rasid, 1 November 2018)
Middle East and North Africa Weekly (Giyas M Gokkent, 15 October 2018)
COMMODITIES RESEARCH
CROSS-ASSET STRATEGY RESEARCH
US CREDIT RESEARCH
ASIA PACIFIC EQUITY RESEARCH
OIL AND GAS EQUITY RESEARCH
EMERGING MARKETS EQUITY STRATEGY RESEARCH
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