Oil: Both Saudis, US Playing for That 1 Unturned Card - Iran

The diplomatic relationship between Saudi Arabia and Iran indicates a strengthening bond. The increase in Iran's oil production poses a challenge to Saudi Arabia's attempts to stabilize prices. The future remains uncertain as Iran's expanding production and the introduction of stored oil in China may have an impact on crude prices.

Seven days ago, the Saudi Crown Prince, Mohammed bin Salman, engaged in a gathering with the Iranian Foreign Minister, Hossein Amir-Abdollahian, in the city of Jeddah. This encounter was primarily orchestrated to exhibit a significant moment in front of a global audience.

This week, Saudi Arabia and five other countries, notably Iran, expressed their intention to become members of BRICS, an economic alliance led by Brazil, Russia, India, China, and South Africa. Additionally, Riyadh made known its plans to invest $16 billion.

In the past, the Saudis and Iranians were fierce adversaries in the Arab world, but now it appears they have grown significantly closer.

However, there is another development in progress that may put their inexperienced diplomatic skills to the test: a greater-than-anticipated influx of Iranian oil entering the market.

The second occurrence became apparent this week following a Reuters report which relied on significant alternative sources regarding oil production. The report stated that in August, OPEC's oil production increased by 220,000 barrels per day. OPEC is an abbreviation for the 13-member organization called the Organization of the Petroleum Exporting Countries, led by Saudi Arabia. The primary reason for this rise was attributed to a significant increase in the supply of oil from Iran.

Iran has been a core member of OPEC since its formation in 1960. However, starting from 2018, it has held a somewhat marginalized position within OPEC. This is primarily due to the oil export sanctions imposed on Iran by former US President Donald Trump. The reasoning behind these sanctions was the accusation that the Islamic Republic was actively pursuing the development of nuclear weapons.

The restrictions previously imposed on the Iranian economy used to be a significant obstacle. Nowadays, they have minimal impact on Tehran, primarily due to the lack of strict implementation by President Joe Biden's Democratic administration, following the Republican presidency of Donald Trump.

As Iran enters its sixth year of sanctions, it enjoys the privilege of being exempted from any production cuts imposed by OPEC. The lack of enforcement regarding these sanctions allows Tehran to freely export as much oil as it desires, without the need for transparency. However, on occasions, they do provide updates. In late August, Oil Minister Javad Owji informed parliament that Iran's production capacity has now reached 3.8 million barrels per day. Presently, they are producing 3.2 million barrels per day, with a goal of reaching 3.4 million by the end of the summer. Nonetheless, similar to Russia, a country also subjected to US sanctions due to its invasion of Ukraine, there is a tendency to doubt Iran's statements regarding their oil production. Sanctioned countries often tend to boast that the measures taken against them are ineffective.

The Saudis, naturally, possess knowledge about the quantity of oil Iran is currently producing and exporting through OPEC's monitoring system. However, the Reuters article indicates that Iran may be speaking honestly, stating that their oil output has increased to a range of 3.1 to 3.2 million barrels per day compared to the average of 2.9 million barrels in July.

Aside from Iran, Nigeria increased its daily oil production by 20,000 barrels in August, according to a report from Reuters. This increase in supply from OPEC nations last month effectively cancels out almost half of the reduction made by Saudi Arabia, as highlighted by Adam Button, an economist who tracks the oil industry on the ForexLive platform.

The lollypop cut was first mentioned in June by Saudi Energy Minister Abdul Aziz Salman. He used it to describe the kingdom's decision to voluntarily reduce oil production by one million barrels per day in July. This term has now become widely known in the oil market, as the Salman brothers are determined to raise oil prices to $100 or more per barrel. They have consistently implemented these production cuts on a monthly basis and have even warned of further reductions if crude prices continue to fall.

Assisting the Saudi endeavor are the Russians, who have been actively involved in the larger OPEC+ coalition since 2015. The Russian government, which essentially requires sufficient oil sales to back its military efforts in Ukraine, has chosen to adopt the Saudi approach of reducing production in order to increase revenue per unit of oil.

The outcome of the joint effort between Saudi Arabia and Russia has been unpredictable and varied: Crude oil prices experienced a substantial increase of almost 20% from July to mid-August, but then dropped to a low point within a one-month period. However, they managed to recover by climbing 7% in the most recent week. Additionally, it is important to note that oil demand typically decreases during September and onwards due to seasonal factors. Nevertheless, Saudi Arabia aims to defy this trend by implementing substantial reductions in global supplies and stockpiles, in the hopes of making a significant impact.

This is where the significance of Iranian oil grows.

During the Trump administration, the 'House of Saud' had no concerns about controlling its former adversary, as the Republican president was effectively handling the situation. However, in 2019, Tehran retaliated fiercely by orchestrating an assault on Saudi Arabia's oil facilities and infrastructure, with assistance from its Houthi partners. This unexpected attack left Riyadh momentarily shocked.

During Biden's tenure, he has maintained the sanctions on Iran that were imposed during Trump's era, albeit with minimal enforcement. This situation could potentially pose a challenge to the Saudis, as was the case with Russia for an extended period. Iran may appear to be an ally within the OPEC, but in reality, their allegiance is questionable.

Even prior to the conflict in Ukraine, Russia frequently shipped out a greater amount of oil each month than what was agreed upon with Saudi Arabia. As a result of the war and the imposition of sanctions on Russian oil, particularly the G7's price limit of $60 per barrel, the Kremlin started to transport crude oil in large quantities, utilizing clandestine techniques honed by the Iranians over the past five years. Additionally, offering discounts on prices became a common practice, with a barrel of Russian urals being sold for $20 less than the global standard. This global benchmark itself dropped from almost $140 per barrel in March 2022 to below $72 by June of this year.

Are Oil Prices Facing Uncertainty?

If given the chance, the Iranians have the potential to disrupt the Salmans' plans for oil prices. Initially, during the Trump administration, their daily production of oil dropped to a low of 2.1 million barrels. However, they have steadily increased it by 1.1 million barrels. There is room for further growth. In 2017, before the sanctions imposed by Trump, Iran reached its highest ever oil production of 4.8 million barrels per day. It is uncertain whether they will be able to reach that level again. Increasing oil production requires additional investments in drilling and infrastructure, which can be challenging for Iran due to the financial impact of years of sanctions. Nevertheless, this month, $6 billion of Iranian assets frozen in South Korean banks were released in exchange for US prisoners held by Iran. This proves that the White House is open to making more deals with Tehran if necessary.

And prices of $80 or more for Brent, compared to the low prices of $40 or below during the pandemic, is a great opportunity for Iran to increase its production. If prices reach $90 or even close to $100 per barrel, Iran could follow Russia's recent strategy of offering its barrels at a discount of $20 or more. This discounting by Iran will gradually and surely impact global crude prices. Chinese and Indian buyers, who had accumulated large amounts of inexpensive Russian oil over the past year, will be eagerly waiting to take advantage of discounted Iranian barrels. Despite the current tight global supply situation, these buyers have been slowly decreasing their inventory.

The apparent involvement of Saudi Arabia with Iran encompasses more than just the oil industry. The reconciliation between these once fierce adversaries, surprisingly mediated by their newfound partner China, is a component of a broader diplomatic strategy centered around a massive economic and social development initiative called Vision 2030, which was devised by Mohammed bin Salman.

The Saudi crown prince must avoid escalating tensions with Iran to prevent potential harm to the project's funding, hinder much-needed foreign investment, and ruin Saudi Arabia's aspirations of becoming a regional and global hub, especially in the areas of cloud computing, logistics, trade, and industry. The incident in 2019 where the Saudi oil facilities were attacked serves as a reminder of the consequences that such escalations can bring, something the Saudis would rather not experience again. Additionally, the crown prince is keen on demonstrating his abilities as a skilled negotiator and statesman who is not controlled by anyone, particularly the United States. The era of relying on the United States for Arab security and the United States depending on stable and affordable Saudi oil is largely coming to an end, although it may still be mentioned in official statements.

The US, recognizing the situation, is responding to Saudi Arabia's actions by launching a persuasive campaign of its own. It is proposing a Saudi-Israel agreement that might certainly irk the Iranians, who view Jerusalem as a formidable adversary compared to the Saudis. Although Riyadh has not rejected the agreement outright, its acceptance would assist Washington in regaining some control over the House of Saud. However, the most significant aspect is that it would halt the increasing influence of China in that region and globally.

Amidst everything happening, the upcoming provision of Iranian oil and the existing stockpiles in storage are worth considering. It is believed that around 12 million to 14 million barrels of Iranian crude are currently being stored in Chinese ports under the label of "bonded storage", awaiting approval from the United States to be utilized for business purposes. This oil was sent to China prior to the implementation of the sanctions imposed by Trump. China holds this crude in bonded storage, which implies that the oil has not yet passed through Chinese customs and remains unused, thereby avoiding any violation of the sanctions for now.

Whenever these barrels are introduced to the market – whether through exemption from sanctions or other confidential agreements between the US and Iran – they have the potential to exert an equivalent influence on the prices of crude oil.

Biden's ability to remove sanctions on Iran solely depends on reinstating the nuclear agreement made by his former superior, Barack Obama, in 2015. However, Israel strongly opposes this deal. Moreover, given that the Republican party now has control over the US congress, they would vehemently resist such action. Therefore, the most favorable path for Biden to promote US interests would be to initiate a peace agreement between Saudi Arabia and Israel, while also granting Iran the freedom to export oil without significant concerns about sanctions. Additionally, efforts are underway in Washington to encourage Venezuela, which was also subjected to sanctions by Trump, to increase its oil production.

Exciting times lie ahead for the oil industry as the major players in the global commodity realm compete for the grandest rewards.

Please note: The information provided in this blog post is solely for educational purposes and should not be considered as a means of encouraging or advising to engage in the buying or selling of any commodity or related securities. The writer, Barani Krishnan, does not possess any holdings in the commodities or securities mentioned in this article. He often incorporates various perspectives from sources other than his own to provide a diverse analysis of different markets. Occasionally, he may present opposing views and market factors to ensure impartiality.