July 31, 2018

The Trump administration's Iran strategy may be high-cost, low-return

The U.S. administration’s signals that it will take a tough line on the reimposition of Iran oil sanctions in November, notwithstanding indications that it may consider some exceptions, have made waves in the market and diplomatic communities. The oil price spiked last month on the news that the administration appears willing to spend significant, near-term diplomatic capital to completely beat back foreign governments and banks involved in Iran’s oil trade. The administration’s most recent threats against Iran over its destabilizing activity in the region only further underscore an aggressive posture in the conduct of foreign policy and willingness to stoke controversy and conflict in a very high stakes region. It is clearer than ever that the points of contention between Washington and global capitals are deepening. Particularly with respect to sanctions, this policy approach may be recklessly unenforceable, and the returns for U.S. leverage will be wanting.

The Market Reaction

In late June, oil prices rallied on reports that the U.S. State Department urged buyers of Iranian crude oil to reduce their import volumes to zero when sanctions on oil purchases kick back in on November 4. In the statement, made in a call with reporters, the official also noted that the U.S. administration was not inclined to grant waivers for “significant reductions” in purchases of Iranian oil to major buyers, as had happened when the Obama administration sanctioned Iran. Since the call, the State Department has provided some leeway by invoking a “case by case” decision on whether to impose sanctions, but still confirmed the aim of reaching zero Iranian oil exports, down from the early 2018 levels of 2.5 million barrels per day.

Given these government statements, even if hedged, the market should expect much larger oil output reductions than many observers initially expected. These will exacerbate the already ongoing tightening of the oil market and cause increased uncertainty for businesses in the sector and global consumers. If the administration tightens the screws on oil reductions without consulting more extensively with major buyers, or without a clear vision of where alternative supplies will come from, it will directly contribute to an increase in the price and volatility of this key commodity even further. Should sanctions implementation and waiver decisions come down to the last minute in an effort to push more Iranian supplies offline, the impact could be greater. This poses a risk to global and U.S. consumers, who may see their gasoline prices rise at a time when there are already some signs of stalling macroeconomic growth. Among those affected, U.S. and Asian emerging market consumers tend to be most vulnerable to such price rises, which dampen their consumption of other goods and services. 

Using U.S. sanctions to remove Iran’s roughly 2.5 million barrels per day export volume from the market (or even a more realistic 1.5 million barrels) would be difficult under any circumstance. This administration already faces significant administrative and enforcement challenges to follow through on its maximum pressure economic strategy on Iran and Iran’s business partners. These include primarily European and Asian economies such as China, India, Japan, Turkey, the United Arab Emirates, Italy, and Greece. This maximum pressure strategy is even more difficult to implement without consistent communication with other foreign oil suppliers (mostly OPEC members like Saudi Arabia) that would need to provide the offset. It appears that the administration is still in the initial stage of its international meetings with Iran’s major buyers, with key encounters with a number of countries like India and Turkey only occurring in July. 

Given the U.S. administration’s contentious trade discussions with many of the same consumers, particularly China and Europe, reimposing such extensive sanctions on the financial transactions associated with the oil trade will be particularly fraught. The risk of price volatility will be ever present, which could increase supply chain uncertainty and the cost to consumers. That will certainly hit close to home for U.S. motorists right as the country prepares for midterm elections. Coincidentally, this timeline coincides with the period when many of the planned tariffs and countermeasures for various elements of the trade agenda may also kick in, adding to price uncertainty for U.S. consumers. Thus, it could also make achieving some of the U.S. trade goals that much more difficult, which may also impact midterm election conversations.

Many Open Sanctions Questions

Even as the oil market seems to have absorbed the news for now, and is now adopting a wait-and-see approach, the U.S. administration’s aggressive sanctions enforcement posture raises more questions than it answers. Most importantly, observers are not sure whether the State Department’s statements are a true articulation of U.S. policy toward Iranian oil purchasers, or merely a messaging strategy to scare away business from Tehran. For one, State Department officials have made various statements about Iran sanctions implementation without apparent coordination with Treasury officials who authored much of the Iran sanctions guidance and will be critical in enforcement. The White House messages about the price of oil and supplies on the market, as well as threats targeted at Iran, also appear uncoordinated with administration agencies. 

Putting aside questions about the specific goals of the U.S. administration on Iran sanctions and how far it will go to drive Iranian oil off the market immediately after the November deadline, the assertive posture is credible. Officials are undeterred in their embrace of unilateralism, despite the likely challenge in the execution of sanctions.  Pre-JCPOA sanctions on Iran worked because they were crafted and implemented multilaterally, which helped mitigate some of the enforcement challenges. During the 2010 to 2016 sanctions on Iran, Washington worked to ensure buy-in from partners and to create flexibility to try to avoid large-scale price increases. That is why U.S. policymakers created “significant reduction” waivers in the first place. These measures allowed countries to gradually decrease their purchases from Iran without rocking the market or increasing domestic vulnerabilities of importing nations that sourced over a fifth of their oil from Iran. The waivers also gave leeway to U.S. policymakers in choosing to punish countries that did not comply, weighing the need to tighten Iran sanctions against other foreign policy priorities. 

This leads to the question of whether the new U.S. approach toward oil reductions, if real, will work. Certainly, it will raise the level of animosity between the United States and countries winding down their purchases of oil. European nations, and the EU as a group, have tried hard to maintain some semblance of an economic relationship with Tehran to uphold their end of the Iran nuclear deal and incentivize Iran to stay within its bounds. European companies, however, have mostly limited their exposure or, in the notable case of Total, announced a halt to planned project activity, a decision that reflects both sanctions-related financing risks and domestic implementation of policies within Iran. With expectations of a November 4 full drawdown in oil purchases, Washington seems likely to add unnecessary acrimony from Europe to a process that would have likely occurred fairly quickly anyway for business reasons. The U.S. policy course also risks widening divides within European states that may complicate concurrent policy initiatives on trade.

In East Asia, the aggressive U.S. posture and the questions surrounding sanctions enforcement may cause more long-term damage to U.S. sanctions policy. By charting such an aggressive course, the administration has backed itself into a corner. Even in countries that comply out of fear of U.S. sanctions, actors will certainly have strong incentives to create instruments to shield themselves from major sanctions market-moving decisions from Washington in the future. For example, they may consider exploring some non-dollar denominated oil trading mechanisms or alternate payment systems to shield themselves from U.S. sanctions when making energy purchases. China is already poised to promote avoidance of U.S. sanctions by offering trading activity in its renminbi-denominated oil futures contracts, though market participants have yet to adopt these instruments on a widespread basis and trading volume remains very low. If these measures became more popular, they will limit the reach of U.S. sanctions and blunt their future effectiveness. These market adaptations could, then, deprive U.S. policymakers of sanctions, a tool they have unfailingly reached for in the event of a foreign policy crisis.

What Happens Next

The biggest Iranian oil purchasers, including major countries like China and India, are the least likely to fully wind-down their imports, especially if Iranian authorities are willing to provide discounts. To back up its threat of sanctions, Washington may find itself having to sanction a bank supporting oil trade in such a country. In doing so, Washington could alienate these international counterparts in another major foreign policy file. Moreover, the U.S. government would be sure to increase uncertainty in global financial markets via counterparty exposure.

Some of the fall-out from the new U.S. government guidance on maximum oil sanctions enforcement is fairly predictable. European businesses and those in major developed economies in Asia, especially Japan, which barely increased trade after the JCPOA, are likely to cut their exposure to Iran quickly and look for new sources of energy. Although businesses in Europe and Asia are already reducing their orders of Iranian crude, it would be very difficult to achieve the goal of reducing Iran’s oil exports from the current 2.5 million barrels a day to zero by November. The key buyers—including China, India, Turkey, South Korea, and Japan—all maintained some, admittedly reduced, level of purchases of Iranian oil even during the period of maximum sanctions pressure prior to the JCPOA. Three European countries—Italy, France and Spain—also import notable amounts of Iranian crude and may be reluctant to reduce completely unless or until Iran walks away from the nuclear accord, which it has threatened to do. The EU, which collectively eliminated its imports in 2012, looks reluctant to do so now. Political leaders have introduced blocking restrictions that would prevent European companies from complying with U.S. unilateral sanctions, even though these may have a very limited effect on European companies pulling away from Iranian oil supplies. 

Recent OPEC pledges to increase supply do not provide much breathing room. The cartel’s supply increases barely cover past outages let alone future ones. OPEC’s compromise deals may actually add to uncertainty. Meeting in Vienna, OPEC and their allied producers including Russia (a group known as OPEC+) agreed only to reduce overcompliance with their mandated targets, with each country encouraged to increase production to the previously approved quota rather than increasing output as a group, or formally committing to replace Iranian barrels. 

There are both physical and policy constraints to replacing Iranian oil. Only a few countries are physically able to pump more – Saudi Arabia, Russia, the UAE, and Kuwait among them. These countries have yet to figure out how to replace the losses coming from Venezuela’s rapid production declines. The U.S. demands on import reductions from Iran certainly complicate the picture for OPEC decisionmakers, who may struggle to hold together the new alliance or even to add the additional 2 million barrels that would be required. Even if the members of the group solve the political issue of how to allocate and make up for the lost supply, zeroing out Iran’s exports would use up much (if not all) of the spare capacity within the group. It is not clear that OPEC could have done much differently given Iran’s status in the group, but its purposefully vague statement will increase focus on conflicting data and may add to global economic volatility.

Meanwhile, U.S. policies relevant to Iran and oil markets have moved in contradictory directions. President Trump and other officials have blamed OPEC for higher prices, as their cuts (planned and especially unplanned) helped tighten the market. To date, OPEC and the cartel’s partners have responded slowly in plugging the Venezuelan production decline and other potentially more temporary outages in Libya and Nigeria as they mounted. At the same time, the lack of clarity about U.S. sanctions and enforcement timelines engendered greater market volatility. For this reason, the administration has had to go back to major oil producers to create a workable compromise, creating further confusion in the process. Faced with this danger, President Trump has tweeted about a commitment from Saudi Arabia to increase production to make up for the production being taken off the market. The White House had to then walk back the statement noting that Saudi Arabia just noted that it would be able to increase production if needed. The Saudi government reiterated this statement. This all means that additional supplies may lag, and there may be greater price volatility. OPEC’s shift to a short-term “data-dependent” mode may suggest more focus on short-term production calibration rather than longer term supplies. To be sure, the increase in U.S. production, mostly from the shale patch, continues to add to global supply helping to respond to the increase in global demand. However, limitations in U.S. oil infrastructure will be a cap on further American supply to ease turbulent markets through the near term. That means U.S. producers cannot play the supply bailout role they did during the last tough sanctions on Iran.  

Iran’s Likely Reaction

Applying extreme sanctions pressure to quickly reduce Iranian output presents several key geopolitical and market implications for Tehran. First, it increases Iran’s reliance on China and Russia, for either direct purchases or resale, as well as for direct investment in the country as European and other planned investment does not come to fruition. European political leaders are trying to preserve business ties with Iran, but there is little they can do to compel their banks and companies to risk violating U.S. sanctions. While China is unlikely to sharply increase its Iranian oil purchases given the risk of U.S. sanctions and its desire to maintain economic and political ties across the region, it is equally unlikely to abandon its interests including energy joint ventures. Recent reports suggest China is upping the ante on such investments.

Second, driving Iran exports to zero increases risk of smuggling and re-exporting discounted oil as Iran tries to retain some market share and revenue. Already, Iran has been offering discounted supply for key buyers over long-term contracts. This could increase, making it difficult to hit sanctions enforcement targets. Moreover, if demands for full drawdowns in oil purchases from Iran continue to boost prices, Tehran could benefit from growing revenues even as its export volumes go down.

The new U.S. enforcement posture and the sanctions implementation to come will no doubt increase the damage to Iran’s economy. It is likely to slow sharply and possibly experience a technical recession in 2019 if oil production falls. The country already faces a currency crisis. It has an effectively frozen banking system, which is reluctant to lend to the private sector. Additionally, Iran was experiencing challenges attracting investment and carrying forward projects even before the U.S. withdrawal from the JCPOA. Meanwhile, high interest rates, fiscal constraints, and stagnant wages are contributing to recurrent protests. The new sanctions and the telegraphed intention of U.S. seriousness around enforcement will compound these already existing vulnerabilities in the local economy. These trends will further weaken the future flows of investment (as past projects remain on hold) and threaten to weaken the energy sector contribution to the economy, as well as government revenues. A significantly weaker currency is sharply increasing the cost of imports. Volumes had already begun to drop in early 2018 as investment and consumer demand began to slow. 

These negative outcomes are undoubtedly part of the aggressive sanctions’ goals. Iranians are unhappy about the loss of their purchasing power as the currency remains in free fall. The rial, which reportedly hit 100,000 against the dollar briefly, seems to be struggling to reach a bottom as the authorities are unable or unwilling to supply the necessary foreign currency or store of value.  Early reports suggest that the new (third) exchange rate will not provide more stability. This vulnerability will remain self-reinforcing, contributing to a macroeconomic downturn.

Despite these vulnerabilities, it is important to remember several sources of Iranian resilience. These include local food production and the ability to reduce imports (as happened under previous sanctions) and to increase exports which can improve the external balance, including with some regional partners. Other Iranian tools, such as the ability of the government to keep banks on life support and some past savings that are supporting local investment projects, may also contribute to Tehran’s resistance. Finally, investment from China and Russia could provide some important capital. This economic outlook is not a particularly strong one, but it would be dangerous to count Tehran out or to assume that a weakening and more inward-focused Iran would be more open to U.S. interests in the region. 

The Geopolitical Fallout 

All these domestic economic difficulties suggest that the Tehran government’s position will become weaker. But the fallout from this decision will not occur in a vacuum. The aggressive posture on sanctions enforcement may cause difficulties in finding partners to solve other pressing foreign policy matters.

Through its aggressive oil sanctions, the U.S. administration has signaled that the Iran file is one of its most important. Yet, even as it clearly has elevated importance, it is not alone. China is the elephant in the room. The developing trade war with Beijing and the tense negotiations with North Korea are similarly high stakes, and may be even higher for the White House.

Earlier in July, Secretary of State Mike Pompeo traveled to Pyongyang to advance the nuclear negotiations with the Kim regime. Though the American side expressed hope for the process, the North Korea Foreign Ministry issued a statement criticizing U.S. demands as “gangster-like” and arguing that the negotiation had entered “a dangerous phase that might rattle our willingness for denuclearization.” There remains major skepticism about Pyongyang’s willingness to make major irreversible concessions to U.S. requests. If these negotiations fall through, the United States will find itself trying to return to maximum pressure on North Korea even while it pursues complete oil export cuts against Iran. China will be the key player in both of these programs. Washington policymakers will then have to choose where to dial up the pressure to ensure compliance. Under pressure to strengthen two major sanctions programs, the United States will then be more likely to target a major Chinese financial institution—increasing the potential for destabilizing consequences for the global financial system. Alternatively, policymakers may find themselves concentrating their leverage on one of the two sanctions programs, though it is unclear which one they may choose. 

Even when it may not directly conflict with other U.S. policies, the aggressive U.S. posture may give Beijing increased leverage. In the trade war, by making this additional ask of Beijing on Iranian oil cuts, the United States has given one more card for Chinese policymakers to play. They could, for example, trade decreased purchases from Iran for easing of punitive U.S. measures. More generally, the sanctions will distract from longer-term U.S. policies to counter China’s rise. Even as the administration has signaled its intention to shift to a great power competition mindset, as it articulated in its National Security Strategy, the Iran pressure campaign will be a major distraction. By spending diplomatic capital on getting partners like India to reduce their Iranian oil imports, and potentially sanctioning their financial institutions, the United States will be diverting its focus from strengthening its relationships in the Indo-Pacific. Already, the U.S. exit from the Iran deal may make it harder for countries like Japan and India to build their naval bases meant to counter Beijing’s expanding maritime footprint. Now, the United States will be once again diverting its Asian partners from what should be a singular focus on a rising China. By putting the administration in a position of asking Saudi Arabia to increase its oil production, the aggressive Iranian sanctions force Washington to deepen its entanglements in the Middle East, tethering its policy to Saudi Arabia and making it harder to push its gaze further east. 

Finally, reducing Iran’s oil revenues is likely to increase those of other oil producers. These include allies like Saudi Arabia but they also include Russia, which is poised to increase oil production and revenues. Iran too will receive more money per barrel for what it does manage to continue to export, undercutting the desired effect of the sanctions. Regarding Russia, with more revenue per barrel it is likely that Moscow will increase its reserves and domestic resilience, denting its exposure to any U.S. sanctions. Russia, a strategic U.S. competitor and ally of Iran, has already increased its influence in the region. In addition to its short-term benefits from increased oil revenues, Russia may also acquire broader influence as a formal or informal trade and political intermediary, including via smuggling oil. These developments may make it even more difficult for Washington to counter Russia’s malign behavior such as election meddling.

These significant potential geopolitical implications lay bare the new world ushered in by the aggressive U.S. enforcement posture toward Iranian oil imports. Just a few statements from State Department officials have sent major shivers across global oil markets and President Trump’s tweets will continue to sow confusion about the direction of prices, politics, and the economy. Countries are scrambling to adapt, even while major sanctions questions remain open. Yet, it is not clear that a more unstable Iran, and greater costs for global consumers, will support U.S. security.