This is part 1 of a 3 part series which we are writing in order to give investors a guide on how to protect themselves and profit from economic sanctions on Iran. Part 2 will focus on a retail portfolio and Part 3 will focus on precious metals.
The European Union imposed economic sanctions on import of oil from Iran on July 1, 2012, which brought the import of the fuel from the Islamic republic, in the EU, to a complete halt. The union also banned insurance of oil tankers from Iran; which has a negative impact on shipments from Iran to other countries.
As per expectations, the European Central Bank reduced interest rates by 25bps to a record level of 75bps, and China may decrease lenders' requirement ratio, to provide a stimulus to the economies in both regions, which can help oil prices trade higher. However, the statements of the ECB President signaled an economic slowdown that is expected to exert negative pressure on oil prices.
The U.S. and its allies have been imposing economic sanctions on Iran to discourage the country from acquiring Nuclear weapons. The sanctions have been gradually imposed since 2011, to encourage Iran to resume talks with the United Nations (U.N.) and to allow International Atomic Energy Agency (IAEA) inspectors to visit and inspect its nuclear facilities.
Factors Affecting Oil Prices in 2011
CY2011 was an eventful year for oil prices, as witnessed in the commodity's price volatility. WTI and Brent prices, at the beginning of the year, were $91.38/bbl and $93.23/bbl, and the year end prices were $98.83/barrel and $108.09/bbl.
That year witnessed the Arab Spring revolutions, extending from Egypt, Libya, Syria and Yemen, the imposition of economic sanctions by the U.S. and its allies on Iran, and the debt crisis and recession in the European Union.
The prices of WTI peaked at $113.39/barrel on April 29, 2011, and the prices of Brent peaked at $126.64/bbl on May 2, 2011, after the Arab Spring risings had halted shipments from Libya (the third largest producer in OPEC).
Factors Affecting Prices in 1Q2012
Iran has repeatedly refuted all claims regarding its intentions of acquiring nuclear capability and Uranium enrichment for military purposes, and has time and again claimed that it is acquiring nuclear capability for civilian purposes.
In December, Iran threatened to block the Strait of Hormuz after the imposition of economic sanctions by the U.S. and its allies.
WTI and Brent prices, at the end of 1Q2012, were $103.02/barrel and $123.41/bbl, as compared to $98.83/bbl and $108.09/bbl, at the end of 2011. Prices peaked at $109.77/barrel on February 24, 2012 for WTI, and at $128.14/bbl for Brent on March 13, 2012.
Factors Affecting Oil Prices in 2Q2012
The recession and the debt crisis engulfing the European Union have had a negative impact on oil prices. As witnessed in April, the prices of oil witnessed a significant downturn after an anti-bailout party in Greece showed strength in the electoral, suggesting that the country may exit the European Union.
On the other hand, the U.S. and China have demonstrated signs of slowdown in their economies, which have contributed to declining oil prices in 2Q2012.
Iran, on the other hand, allowed IAEA inspectors to visit its nuclear facilities to ease mounting tensions, and retreated from its stance on June 6, 2012. Brent dropped 21 percent from April 14 till June 19, 2011, when the first international talks, in 15 months, were held with Iran on its nuclear program in Istanbul. Russian, British, Chinese, French, German and U.S. delegates met with their Iranian counterparts on June 18, for a third round of discussions over two days, at a hotel near Russia's Foreign Ministry.
Prices dipped to $77/barrel on June 27 for WTI, and the price at the end of 1H2012 was $85/barrel, as compared to $103.02 on March 30, 2012.
Prices dipped to $88.69/bbl on June 25, 2012 for Brent, and the price at the end of 1H2012 was $97.8/barrel, as compared to $123.41/bbl on March 30, 2012.
Impact of Embargo Imposed by EU
The European Union imported 18% of Iran's oil shipments, which were approximately 396,000 barrels per day. The sanctions imposed by the EU not only boycott import of oil from Iran, but also ban insurance of oil shipments from the country, which will further dent the country's output.
Exemptions Provided to India/China/Singapore
The U.S. has provided 20 countries, including China, India and Singapore, exemptions from economic sanctions, as they curtail their imports of oil from the Islamic republic.
Threats to Block the Strait of Hormuz
The Iranian government has time and again threatened to block the Strait of Hormuz in retaliation to economic sanctions imposed for pursuing its nuclear ambitions.
According to reports Iran's parliament is in the process of introducing a bill to shut the Strait of Hormuz to oil tankers from countries applying EU sanctions. The passage is a transit route for a fifth of the world's crude and any development will cause oil prices spike.
Also, Iran's Revolutionary Guard Corps initiated a military exercise on July 3, 2012 and fired several long range missiles.
Impact of Sanctions on Output & Exports of Iranian Oil
It is widely anticipated in the market that Iran's output (second largest producer in OPEC) will drop from 3.3 million barrels/day to approximately 2.4 million barrels/day. It is also expected that Iran's exports, currently at 2.2 million barrels/day, will drop to 1.5 million barrels/day, and may even drop to 700,000, if sanctions persist and countries currently importing oil from Iran keep reducing imports to avoid sanctions from the U.S.
Increased Output from Saudi Arabia and Iraq
Saudi Arabia has increased its output to 10 million barrels/day to fulfill any shortfall created due to the sanctions imposed on Iran, and has continued to produce at this level as per its commitment.
Iraq, on the other hand, has seen an uptick in the output of its oil, and its output is expected to reach around 3.4 million barrels/day, nearing levels not witnessed since the First Gulf War.
Outlook for Oil Prices
As mentioned above, any reduction in the oil supply from Iran is expected to be compensated for by Saudi Arabia and Iraq. However, if Iran comes through on its threat to block the Strait of Hormuz, the act will increase oil prices significantly, since not only will the Islamic republic block a fifth of the world's oil supply, but would also trigger further conflict in the region.
We are of the opinion that Iran will avoid an armed conflict and not block the Strait of Hormuz.
At the other end of the spectrum (as mentioned above), there were expectations that the European Central Bank may cut interest rates by 25bps, and the People's Bank of China may reduce the reserve requirement ratio of banks, to provide a stimulus to their respective economies.
The European Central Bank (ECB) cut interest rates to a record low of 75bps on July 5, 2012, but oil prices declined due to a statement by the President of ECB, Mario Draghi, in which he said, "Downside risks to the Euro area's economic outlook have materialized."
The Brent witnessed a dip due to speculation that the Norwegian government may intervene to end the strike that has shut oil production in the North Sea.
The above factors will affect the prices of Brent oil more than WTI.
Also, oil inventories in the U.S. dropped by 4.3 million barrels as compared to expectations of 2.3 million barrels, which may exert pressure on oil prices in the U.S. in the short term. Another major trigger for oil prices is the payroll data, which was released today. The unemployment rate held at 8.2%, while payrolls increased by 80,000 in June after a 77,000 increase in May. The payroll increase data has come in lower than the mean estimated increase of 100,000, and is a sign that the economy is softening. The lower than expected increase in employment data will exert negative pressure on oil prices.
How to Play this theme:
We are recommending a long/short strategy to benefit from Oil sanctions on Iran. We recommend that investors take a long position in the Oil and gas services sector ETF (NYSEARCA:OIH). It has a high correlation with oil prices, since any movement in oil prices affects the level of drilling and exploration spending (Upstream spending). Higher drilling activity improves the bottom line for oil servicing companies.
Investors can also short sell the Retail ETF (NYSEARCA:RTH) and Consumer Discretionary ETF (NYSEARCA:XLY) as retail spending will get hit because of high oil prices. On the other hand, discount stores like Wal-Mart (NYSE:WMT) will benefit. In the second part, we will focus on how investors can shape a retail portfolio in order to benefit from high oil prices. The third part will focus on structuring a commodities (precious metals) portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.