The government sanctions against Iran are working better than expected, but Iran is hell-bent on destroying its own economy … That's great news, if you aren't holding oil.
I don't think enough attention has been given to what will happen when Iran finally surrenders and yields to the demands of the west.
The sanctions themselves are something of a miracle. There has been too much demand for oil for us to effectively bully one of the top 10 producers. The last time we tried to bully one of the top 10 (Iraq), the price of oil doubled in only 16 months (May 2003 to Oct 2004) and doubled again within 4 more years, and continued to increase until the world economy crashed.
Even Libya - with an export of only 1.6 [Mbbl/d] - was able to cause Brent crude prices to spike 27% in 80 days when its revolution erupted and shut in crude production. Messing with oil exporters has always been looked upon as picking a fight with the Lernean Hydra armed only with a cleaver - you can attack all you want but it only makes things worse.
So when the idea of SANCTIONING Iran started really gaining traction, and the market began the fearful realization that "We are really going to do this?!!", the prospect re-introduced a new form of "terror premium" into the markets up over a four month period.
But this market is far different than what we saw in 2003-2008, the terror turned out to be a remnant of our youth which has no bearing on the world today: similar to a fear of the dark, or a fear of monsters under the bed.
The resurrection of the U.S. oil industry:
Part of the reason that this is so is because of the recent ramp-up of U.S. production. As I indicated in my first article, the falling price of natural gas has caused U.S. production to switch from gas to oil at a rapid and increasing pace. From Jan 2009 to Jan 2011, the U.S. liquids production (including crude oil production, NGL production, ethanol production, and biodiesel production) increased by 1 million barrels/day [Mbbl/d]. From Jan 2011 to Jan 2012, U.S. liquid hydrocarbon production increased another [Mbbl/d]. My previous article spells out why I expect that difference to continue to increase rapidly over the next year.
Falling U.S. demand:
At the same time that production in America has been rising, demand for hydrocarbons has been falling. The warm winter contributed to an average drop in distillate demand of ~100,000 [bbl/d] for America, while excessive inventories - and to a lesser extent better mileage vehicles and consolidated driving patterns - have contributed to an average drop in demand of ~450,000 [bbl/d] for the first half of the year when compared to 2011. (What I have listed here as demand is actually the amount of product supplied to distributors. This can be analogous to demand, but there can also be sharp movements from week-to-week based on price and storage issues which may serve to exaggerate trends or give false signals. While the exact month-to-month trends may be exaggerated, however, the accumulated amount distributed during a given period will correlate to the amount of that product which was consumed ... So while it may not be perfectly accurate to say that Jan 2012 saw 821,000 [bbl/d] less gasoline demand then Jan 2011; it is quite accurate to say that first 189 days of 2012 has seen ~83 [Mbbl] less gasoline demand than the first 189 days of 2011).
As of the latest EIA petroleum supply report, the U.S. is importing ~1.5 Mbbl/day less than they were at this time last year.
The world doesn't need Iran's oil:
So the changes in U.S. supply and demand alone could have been sufficient to offset the loss of Iranian crude on their own. But in addition to America: Saudi Arabia supported the sanctions by increasing their export over 1 [Mbbl/d]; there were large additional increases in production from African nations - especially the recovering nation of Libya; there's been an increase in Russian production; an increase in Canadian production; increase in Chinese production; etc. ... All this has occurred while Europe and Japan are in recession, and the rest of the world has been in a downturn.
Since the beginning of March, Brent crude futures have fallen a full $29/[bbl], while WTI prices have fallen ~$23/[bbl]. Iran's extra 1 [Mbbl/d] aren't needed. We can keep the sanctions going until Iran drowns in its own oil.
Now we can get back to the news that should have shocked the world over the last few weeks, but seemed to have gone by without much comment: The sanctions against Iran are working: WELL. Iran has cut its production to the lowest level since the Iran-Iraq war in the 80's. That is something that Iran does not want, as the act of cutting production - lowering the pressure on oil fields - may allow ingress of salt water into the crude reservoirs, which will add an additional separation step and additional cost for the production of many of their wells. But their storage is filling up, and their tankers are stuck in the harbor - riding low because they are completely filled to capacity. As of June 13, an estimated 42 [Mbbl] of crude were floating in filled carriers that couldn't sell. Iran has been desperately increasing storage, but they still have shut in production - because they can't increase storage fast enough.
While it's easy to think of storing oil as an equivalent of storing money … the market doesn't work that way. During the height of the Libyan revolution, there was a staged release of 60 [Mbbl] of crude oil from strategic petroleum reserves in several countries over a period of 14 weeks … This served as a glut of additional oil hitting the market and allowing some commercial build, and the effect on price was dramatic:
You can see from the above graph that when the conflict erupted in Libya there was an initial surge in prices. Prices peaked on April 29, because on May 1, 2011 the U.S. confirmed that they had killed Osama Bin Laden and the "terror premium" which had supported prices for the past 8 years was ripped out of the market over the following month. But prices then started to rise again until early June, when the withdrawals from strategic reserves began. 60 million additional [bbl] of oil over the course of 3 months was sufficient to halt the climb in the Brent markets and cause WTI prices to fall ~$15/[bbl].
Counting the land-bound storage, Iran already has more than 60 [Mbb]l of oil that is ready to be released onto the world markets all at once. At least 42 [Mbbl] are already loaded on tankers. They are currently losing over $95 million per day in lost exports - that's equal to a direct loss of ~0.6% (before multiplier effects are considered) of their entire 2011 GDP every month. Whenever the country finally surrenders to nuclear inspector teams, they will be desperate to dump their oil as fast as possible - certainly in a month or less - in order to be able to resume production ... That is the oil market equivalent of a large dam breaking … the market will face oversupply that will be crushing. So Iran won't recover nearly as much of its lost revenue as it would like, because they will be forced by desperation to destroy the value of their export just by offloading it.
That region of the world has an unfortunate history of passionate but stupid men taking the extraordinary step of destroying themselves utterly in the hopes that they might harm someone else, and after decades of funding such idiocy it seems the Iranian regime has decided to take that step themselves.
Iran is now strapped to a policy that is likely to ruin them - but they're bound to take some other oil traders with them. My suggestion is to stay clear of the oil markets. This is a pact that you don't want to join in on.
I want to point out that it's likely that Iran will eventually bargain to allow the inspectors in if the West agrees to purchase the oil at a premium … which of course will lessen the blow to Iran but will in no way eliminate the issue of a sudden oversupply in the market. However, every day that the Iranian regime blusters their negotiating position weakens while the negotiating position of the West gets stronger. We'll have to see. Either way, any trade in the oil markets should have a "suicide watch discount" rather than a "terror premium". No one wants to be holding oil when Iran's vest goes off.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am part of a small group working on a novel fuels synthesis process, but we are still in lab-phase, and at least 18 months (from the completion of Round A investment) from even having a pilot plant. So any discussion of the oil, gas, or power markets less than several years out has no bearing on my personal prospects.