Iran: Back in the Spotlight

in Market Commentary by

[dropcap]L[/dropcap]ike the roller-coaster ups and downs of the GOP primary polls, Iran has a talent for jumping into the global spotlight, and just as quickly fading back into the shadows. The latest news surrounds its threat to close the Strait of Hormuz should the US, Europe, and other nations bolster economic sanctions—the sanctions, of course, in response to Iran’s reluctance to halt uranium enrichment. We’ve seen this situation before, and it continuously fuels fears of conflict escalation and higher oil prices, which could choke off global economic growth. Past situations have only exerted temporary shocks to oil prices, and it’s entirely possible the current predicament ends similarly. But some new developments have surfaced that could have a lasting, more significant impact on Iran and the world.

Iran’s Oil Industry

It should come as no surprise Iran is predominately an oil producing nation. In fact, according to the Energy Information Administration, oil exports account for half of Iran’s government revenue and almost 80 percent of total exports. Relative to the world, the country ranks second only to Saudi Arabia in OPEC production, and ranks third in global exports. And according to the Oil and Gas Journal, Iran has the fourth largest proven oil reserves in the world. Point being, the country is clearly a major player in global energy markets. As far as exports are concerned, Iran supports a number of large economies. China is the top consumer of Iranian oil, followed by the European Union, Japan, and India.

Iran’s Nuclear Program

Officials in Iran just announced the successful production of a nuclear fuel rod (to be used in a nuclear reactor), which is significant because many doubted the nation’s ability to do so. And anyone not living in a hole in the ground knows at least some historical details of Iran’s nuclear program. The basic gist is despite international pressure to stop, Iran continues to enrich uranium claiming it’s for peaceful energy purposes. But the international community isn’t biting, and most believe Iran’s true intent is to produce nuclear weapons. Even Yukiya Amano, director of the International Atomic Energy Agency, said the following last November: “The information indicates that Iran has carried out activities relevant to the development of a nuclear explosive device.” Seems pretty clear to me.

This is a scary thought. A nuclear armed radical regime, such as the one currently in power in Iran, would pose a major threat to the world. Some, like the US and Israel, believe Iran might even be reckless enough to use such weapons. Maybe they’re right, maybe they’re wrong. Regardless, it’s a significant risk the international community doesn’t want to take.

Sanctions & Threats

Iranian President Mahmoud Ahmadinejad

While the US and United Nations have used sanctions in the past, most were completely ineffective. A big reason for this was China, a member of the UN Security Council. China depends on Iran for oil and refuses to take a harder line and support tougher measures. But over the last few days there have been some noteworthy developments – this time outside of the UN’s scope. First, the US signed into law a bill that would punish foreign financial institutions for doing business with Iran’s central bank. Basically, if they don’t cease operations with Iran they may be forced to cease operations in the US. The goal is to choke off revenue given Iran clears most oil transactions through its central bank. But perhaps more important, Europe appears to be taking a stronger stance. Officials are currently in talks to implement a complete embargo on Iranian oil – let’s not forget Europe is Iran’s second largest consumer.

Combined, these represent the toughest and most tangible sanctions brought against Iran over their nuclear program. And Iran is clearly rattled. As multiple reports have detailed, the country has threatened to close the Strait of Hormuz – a stretch of ocean south of Iran and north of the UAE where, according to the EIA, one-fifth of global oil exports pass.

What is the Likely Outcome and Impact?

Let’s start with Iran’s threat to close the Strait of Hormuz. This simply isn’t going to happen, at least for long. Doing so would likely result in naval warfare between Iran and the US, not to mention choke off Iran’s primary source of income. That’s a poison pill any rationale nation would avoid. And I’m no military expert, but it seems hard to believe Iran’s naval fleet could match that of the US. For a more in depth analysis of a possible battle, this opinion piece by U.S. Navy captain Bradley Russell, who was also chief of staff to the U.S. Navy Central Command in Bahrain, lays it out pretty well.

In other words, recent spikes in oil prices (based on Iran’s threats) are likely temporary. The sanctions, however, may have a longer-term impact. While the US bill and proposed European embargo are set to phase in gradually, both could drive up oil prices over time. In order to prevent shocks to the system, officials are already meeting with other oil producing nations to discuss increasing production and ensure greater shipments to Europe. After all, a European recession is very likely at this point – higher oil prices are the last thing the region needs.

The impact on China, however, might be positive. If Europe, along with other nations, stop purchasing Iranian oil, Iran is going to be short revenue and sitting on a stockpile of oil. As Iran’s largest consumer China would gain a significant amount of bargaining power – the country could buy up oil at fire sale prices. As I’ve detailed in previous posts, China currently faces a significant real estate slowdown. Whether it’s a hard or soft landing remains to be seen, but cheaper energy costs would be an added tailwind that could help bolster economic growth.

And lastly we come to Iran itself. So far, the country has spurned any and all efforts from the international community to halt uranium enrichment. But the international community also never produced a credible threat. These new sanctions do just that: they have the ability to materially impact Iran’s economy. One would hope they represent the final steps in getting Iran’s nuclear program in order, but this can’t be counted on.

The alternative, a military strike against nuclear facilities, cannot be ruled out if Iran remains unresponsive. This type of action may even come sooner rather than later. No one really knows how close Iran is to successfully producing a nuclear weapon, but it’ll likely happen in the next one to three years if nothing is done to prevent it. This means the US and Israel are short on time and may have to take more severe action in 2012. We don’t have any predictions about how the situation plays out, but Iran could be a bigger story than anyone would like this year. If so, it would have a meaningful impact on how capital markets behave, potentially delaying or muting a “recovery rally”.

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Brendan Erne, CFA
Brendan Erne serves as the Portfolio Management Team Leader with Personal Capital Advisors. He has over 15 years of industry experience, spanning almost all levels of the investment process, including several years at Fisher Investments as an equity analyst covering the Technology and Telecommunications sectors. He also co-managed a large cap growth portfolio and co-authored Fisher Investments on Technology, published by John Wiley & Sons. Brendan is a CFA charterholder.

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