The US, Iran, and Oil-Hungry Asia

The steady escalation of tensions between the United States and Iran, most recently brought to a head by attacks on two tankers on June 12, which the United States says Iran was responsible for, have not had a large impact on the oil market. A short-term price rally of 2.2 percent based on rising supply risks evaporated as weakening economic figures overshadowed other concerns for traders, investors, and consumers. Asia – the world driver of oil demand growth – was already watching closely as Washington moved to squeeze out Iranian oil exports in late April. With the odds of a military confrontation rising, the import-dependent economies of the Asia-Pacific need to prepare for rising supply risks in the Strait of Hormuz.

The most recent tanker attacks – one of which targeted a Japanese ship – coincided with Japanese Prime Minister Shinzo Abe’s attempt to tamp down tensions by visiting Tehran directly and encouraging Iranian President Hassan Rouhani to publicly signal Iran’s continued commitment to the Joint Comprehensive Plan of Action (JCPOA). The attacks swiftly ruined any progress made, and exposed U.S. allies and partners to the reality that no other state can adequately mediate. U.S. President Donald Trump has ordered another 1,000 troops deployed to the Middle East to counter Iran. Adding more fuel to the fire, UN officials have since leaked that the United States is planning a “tactical strike” on an Iranian nuclear facility if needed, and Republican senators are aligned in their support of military action as a response to further provocation. What constitutes such a provocation is the open question that markets and Asian importers want the answer to.

Sanctions Ramp up, U.S. Production Mute Price Impacts

Washington’s decision on April 22 to end sanctions waivers for the import of Iranian oil for states like India, South Korea, China, and Japan sent Asia’s leading importers scrambling. As long as the waivers were in effect, the reimposition of U.S. sanctions increased Asian firms and traders’ negotiating leverage as other importers, those not offered waivers, were forced to refuse cargos, driving prices down. With waivers in hand, the major Asian countries also had time to adjust, but that grace period ended in May.

Iranian crude oil and condensate exports reached 2.87 million barrels per day (bpd) in April 2018, just before the United States left the JCPOA. Crude and condensate exports were down to 1.9 million bpd by September as importers were forced to wind down their purchases. By the first half of April this year, data showed daily shipments had dipped below 1 million bpd, though Iran had been drawing on barrels in storage to maintain export levels despite declining production.

As a result of this decline over the year preceding the cessation of waivers, the market had some time to adjust. Rival OPEC producers Saudi Arabia and Iraq initially moved to grab Iran’s market share in Europe by offering more of their equivalent Saudi and Basra oil blends. Further, Russia increased its China-bound exports – dominated by the medium, sour Ural blend – to a record 1.73 million bpd, a more than 50 percent increase year-on-year. The longer runway for Asian importers to wind down purchases from Iran, while Europe found suitable replacements for needed crude blends from other OPEC producers, limited the impact on prices.

At the same time Iranian volumes were taken off the market, U.S. shale production kept rising. Where U.S. oil production stood at 10.46 million bpd last May, it’s now sitting around 12.1-12.2 million bpd. Europe has absorbed hundreds of thousands of barrels of U.S. exports daily and China ended its suspension of major U.S. crude purchases in late April, offering an outlet for several hundred thousand more.

U.S. crude exports are lighter and sweeter than Iranian production, and cannot act as direct substitutes for the same end-use consumer products. Medium sour crude of the type exported by Iran accounts for about 45 percent of the oil produced daily around the world. That has led to a growing imbalance in oil markets since U.S. sanctions have disproportionately reduced supplies of medium sour crude, creating premiums on medium sour blends. But the market price hasn’t yet reflected overall concerns about shortages. In fact, prices for Brent crude – the standard international benchmark – declined from roughly $85 a barrel early last October to under $60 until mid-January this year despite U.S. sanctions kicking in at the beginning of November 2018. After reaching nearly $75 a barrel just after the end of waivers was announced, they’re in the mid-60s caught between worsening economic indicators and the rising likelihood of a military escalation.

Asian Demand and Economic Trends

Four of the world’s five largest oil importers are in Asia: World-leader China, India, Japan, and South Korea. The Asia-Pacific has driven global oil demand growth for the last two decades, and any fluctuation in oil needs from leading markets like China and India has an outsized impact on demand expectations. Chinese imports peaked at 10.64 million bpd in April as firms moved to stockpile supplies. Japan, South Korea, and India all rushed to do the same with Iranian crude, upping their intake in advance of the full force of sanctions.

Despite the short-term bump, market sentiment is turning bearish. The International Energy Agency has revised its annual demand growth projection to 1.2 million bpd, down from an expected 1.6 million bpd projection. OPEC’s demand growth projections are down to 1.12 million bpd, with further room to fall. Demand growth led by the Asia-Pacific’s exporting economies is sputtering closer to zero for the rest of the year.

The effects of the U.S.-China trade war and a changing trade climate have begun to eat into fuel consumption and threaten to push key exporters into recession. Singapore’s May non-oil export figures were down 15.9 percent year-on-year. South Korean overseas sales dropped 9.4 percent year-on-year in May after six months straight of trade contractions. Japan’s May exports declined 7.8 percent year-on-year. Bad figures out of China are the common denominator.

China’s exports reportedly rose 1.1 percent year-on-year for May, with imports dropping 8.5 percent. That decline captures some of the trade pain other regional trade partners are experiencing. The larger picture doesn’t look good. The Trump administration imposed 25 percent tariffs on $250 billion of Chinese exports to the United States, triggering a tit-for-tat response and forcing Beijing to adopt stimulus measures, which have increased lending and debt levels to new highs. Despite the positive export figures in May, industrial production and related indices have trended downward since last June. India isn’t picking up the slack either. Though May exports were up 3.93 percent in May, its trade deficit is widening.

Overall, economic activity in the world’s leading oil demand growth region is slowing down, which takes the edge off of price spikes driven by perceptions of security risks in the Strait of Hormuz. Global trade volumes have declined the last two quarters, and figures look weak going further into summer. This situation lowers price expectations for maritime fuels – the global shipping industry consumes over 4 million bpd of high-sulfur fuels. Rule changes to fuel standards will take out as much as three-quarters of that demand, shifting consumption toward lighter, sweeter oil like that produced in U.S. shale. That further clouds the price outlook, but the continued rise of U.S. production will end up pushing prices down once changes take effect.

While the market is currently baking a global economic slowdown into prices, it doesn’t yet believe that supplies via the Strait of Hormuz might be interrupted. Though Brent prices went up nearly 4 percent with word that Iran had shot down an American drone on June 20, U.S. Secretary of State Mike Pompeo made a hard claim that the strait will remain open. Any sustained closure of the strait or, more likely, significant damage to Saudi Arabia’s Abqaiq oil-processing facility, within range of potential rocket attacks, could create massive market panic. Abqaiq alone has the capacity to purify sulfur and gas from around 7 million bpd. That Rubicon has yet to be crossed. However, insurance rates for tankers transiting the strait are already up over 10 percent. Operating costs are responding to higher security risks.

China’s Response

Beijing initially signaled willingness to defy U.S. oil sanctions in early May, seeking to ensure its continued access medium sour crude supplies and undermine U.S. policy aims concerning Tehran. Beijing tested the waters by purchasing 2 million barrels of crude loaded onto the Chinese tanker Pacific Bravo in the absence of a waiver. In the midst of tense trade negotiations, Washington warned Hong Kong to watch the shipment as it would expose all parties to immediate sanctions action. China’s Bank of Kunlun – a financial institution owned by the China National Petroleum Corporation (CNPC) – promptly denied that it owned the vessel despite reports it had acquired it.

Beijing has not pushed a hard line on crude oil supplies but has begun to use a variety of shipping tricks to disguise the fact that it has continued to import liquefied petroleum gas (LPG) from Iran. LPG has a variety of uses for generating heat, can be used as an alternative fuel for cars, and can be turned into olefins, which provide a base for the production of plastics.

China reportedly snapped up 346,000 tons or 80 percent of Iran’s LPG production in May. China had imposed 25 percent tariffs on U.S. LPG exports as part of its escalating trade war with the United States. A tanker owned by the National Iranian Tanker Company reportedly delivered 1 million barrels to a refinery owned by PetroChina on June 20, with more tankers expected to arrive in coming weeks.

China’s signals have not been matched with strong action to undermine the U.S. sanctions regime on Iran. LPG purchases were likely worth a lowly $80 million for May, further crude flows are not likely to come close to prior levels, and trade talks take precedence over an oil market in which OPEC and Russia will likely continue to play a moderating role to limit volatility. U.S. sanctions on tech giant Huawei are the latest blow the Chinese economy has to absorb, in what threatens to become a long-term fight over tech global value chains. The firm estimates it will lose up to $30 billion in revenues from its loss of access to U.S.-made technology. Iran is ultimately of lesser importance on Beijing’s agenda, and more a political chip than overriding concern.

Japan’s Response

Japan successfully hedged ahead of the revocation of sanctions waivers by cutting its import dependence on Iranian supplies down to a lowly 3 percent as of April. Given its long-standing security relationship with the United States, Tokyo had little appetite to signal policy independence. The country’s refiners have opted to replace Iranian volumes with crude from other Middle East producers. Japan’s JXTG Holdings, the country’s largest operator, projects national oil demand to halve by 2040, which would put daily consumption under 2 million bpd. The relative pressure on Japanese importers is lessened in light of the country’s energy security due to the widely shared consensus among leading Japanese firms that transition toward renewable energy is vital for the climate, as well as insulating Japan from import risks given its near total dependence on imports.

Despite this lesser pressure, Prime Minister Abe has sought to play a role in defusing any conflict that could disrupt the flow of oil exports from the Middle East. After a contentious visit by U.S. President Donald Trump to Tokyo, Abe jumped to offer his services as a mediator with Iranian President Rouhani and Ayatollah Khamenei. The initiative was likely also meant to curry favor in the midst of difficult trade talks with Washington. But Abe’s visit was ruined by explosive strikes on two tankers in the Gulf, one of which was Japanese-owned.

It’s unclear what Japan’s next moves will be. After word that Iran shot down a U.S. drone that Tehran claims had violated its airspace, Trump ordered a retaliatory strike before reportedly calling it off just minutes before being executed. The next morning, Trump tweeted defiantly that the planned response was disproportionate but that Iran can never have nuclear weapons. Abe has virtually no room to maneuver in resuming any mediation efforts, but Japan’s import needs are secure.

South Korea’s Response

Prior to the end of waivers, South Korean imports of Iranian crude had dropped 12 percent year-on-year in March, down to roughly 285,000 bpd. South Korea then ceased all imports in May, after a brief ramp up aimed at securing condensate for refineries geared toward Iranian crude quality levels. Supplies from Saudi Arabia, Qatar, and the United States have filled the gap. In order to offset increased prices for refiners particularly dependent on supplies of Iranian light naphtha, Seoul has extended freight rebates for the import of non-Middle Eastern supplies through 2021. South Korea is the world’s largest importer of Iranian condensate, an ultra-light petroleum product.

Without tempting significant political pushback – South Korea remains dependent on U.S. security guarantees – Seoul has cautiously urged the United States to cooperate for the export of humanitarian aid to Iran. The three-fold surge of South Korean imports of U.S. light sweet and medium sour crudes – 10.48 million barrels for the month of May – has undoubtedly been looked upon kindly in Washington. But South Korean policy is largely stuck aligning with U.S. policy aims as U.S.-North Korea talks over denuclearization stall.

India’s Response

India announced it had ended its purchases of Iranian crude within a month of the U.S. decision to end its waiver, despite initial speculation that New Delhi would defy the imposition of sanctions. Iran is a particularly attractive partner for Indian refiners because they offer longer periods for credit purchases and lower freight rates due to the proximity of export outlets. Saudi Aramco has moved to fill half the gap of Iranian losses – 200,000 bpd – of Arab light crude, but is charging a premium.

Like China and Japan, India has its own trade headaches with the United States. The first evidence of discontent came when Prime Minister Narendra Modi pulled a full reversal and announced India would seek a way to continue its oil trade with Iran and settle accounts without using dollars, dodging sanctions exposure. At the beginning of June, the Trump administration sought to punish New Delhi for failing to adequately open up its markets by withdrawing it from a preferential trade scheme that allowed India to trade certain goods duty free. The timing, however, aligned well with a move also meant to enforce the sanctions regime on Iran.

The two governments are now locked in their own escalatory spiral of tariff impositions with no end in sight. As of yet, Indian refiners have not fully worked out how to respond to maintain their refining slates of needed crude blends on a long-term basis. New Delh’s Petroleum and Natural Gas Ministry has launched new talks in hopes of expanding oil ties with Russia, but given the oil price and sanctions environment, it seems likelier that it’s a signal aimed at Washington. This comes a little over a month after Modi’s administration leaked it that they did not feel comfortable deepening their import dependence on U.S. production, the world’s primary source of supply growth. Policy now appears to be at an impasse while India’s importers scramble to find volumes on the market.

Macro Outlook and Political Risks

Whether by stick or carrot, Asia’s leading importers have largely complied with U.S. sanctions while maneuvering to pursue their own interests to the extent possible. But all face a growing problem due to the cumulative effect of U.S. sanctions on both Iran and Venezuela. Venezuelan crude production is predominantly medium or heavy sour, serving a similar market segment as Iran in many instances. Both countries have seen significant declines in production and exports. On a balanced market, sour crudes sell for less than sweeter crudes because they have more impurities that must be refined out. But there’s a rising relative shortage of medium sour crude and a rising supply of light sweet crude, pushing medium sour blends from elsewhere to trade at a relative premium.

This undermines margins for refiners heavily exposed to fluctuations in the relative cost of crude oil against the refined products they sell. Despite positive signs early in the month, Asia’s oil refiners saw their margins reach 16-year lows by late May. China’s independent refiners operated below 50 percent of their capacity in April and May.

With demand looking weaker, refiners are hit harder by smaller shifts in oil prices. Medium sour crudes are the backbone of the world’s refining demand. Even small premiums have an outsized impact as the imbalance between medium sour and light sweet crude grows. With or without a military conflict, U.S. sanctions policy and U.S. oil production are undermining market stability in tandem.

Oil prices have gained on the latest round of escalation, but demand for refined products is looking weaker and weaker. The eruption of military conflict in the Gulf is a worst-case scenario for Asia’s economies. Though no one knows how much, prices will go up fast until the security situation becomes clearer and more stable. Insurance rates will skyrocket. And world financial markets will become even riskier as investors seek higher yields just as refiners, and by extension consumers, see energy prices rise. That will likely suck out whatever oxygen is currently keeping market sentiment from crashing into completely negative territory.

The deterioration of security conditions will accompany a market shock. It’s impossible to tell what exactly a conflict will look like, though the U.S. Navy is well-equipped and positioned to swiftly secure the Strait of Hormuz. But any attacks on targets in Iran would likely invite a destabilization of Iraq against the presence of U.S. troops. That would, in turn, pose further security problems for oil production. The United States would likely have to significantly increase its deployments.

The implications of a price spike are much more pressing than those of a physical interruption of supplies. But those implications are ugly, and set to accelerate bad economic news already clouding the outlook for oil markets. East of Suez, all eyes are on the Gulf. Whatever happens next, importers and refiners are set to pay.