May 6, 2018 RBC Capital Markets, LLC Helima Croft Global Head of Commodity Strategy Iran: Chain Reaction (212) 618-7798 [email protected] Commodity Strategy Christopher Louney While President Trump has not publicly announced his decision on the May 12 Iran Commodity Strategist sanctions waivers, it seems that the bureaucratic wheels are turning in Washington to (212) 437-1925 [email protected] prepare for a sanctions snapback and a renewed effort to reduce Iranian exports. Michael Tran While there is a scenario where Trump opts to waive sanctions once again due to North Commodity Strategist Korea, we think it is more likely that he opts to exit this week. Yet, whether or not the (212) 266-4020 [email protected] Iranian nuclear deal does die this month or later this summer, the exit terms will be key. Any delay in enforcement or grace period could push the volumetric impact into 2019. Megan Schippmann Associate Strategist While Saudi Arabia publicly promised to put additional barrels on the market last time to (212) 301-1531 avoid higher prices at the pump, their willingness to fill the gap cannot simply be assumed. [email protected] The extraterritorial nature of US sanctions which cover energy, shipbuilding, finance, trade, insurance, etc., means that depending on the enforcement date, Iran’s oil exports could credibly be curtailed by 200-300 kb/d. Also, we caution that the risk could span beyond barrels if Iran opted to resume suspended nuclear activities in a post-JCPOA world. Ready to Roll Once again, decision day for Iran sanctions waivers is looming and we think that it is highly likely that President Trump will exercise the exit option despite the recent best efforts of European leaders to fix the nuclear deal. While there remains an outside chance that Trump will kick the decision until July because of the upcoming North Korea negotiations, we contend that such a delay would only represent a temporary stay of execution for the Joint Comprehensive Plan Of Action (JCPOA). Regardless of whether the nuclear deal dies this week or over the summer, the exact terms of the exit will be very important. A hard JCPOA exit with a swift sanctions snapback would force customers to reduce purchases almost immediately. A more gradual reinstatement of US extraterritorial sanctions would likely entail a grace period to allow foreign refiners to slowly reduce their Iranian imports. While the US would be going it alone this time around in re- imposing sanctions, we believe that the punitive US measures would curb the enthusiasm of European energy companies to invest in Iran and would likely cause European and Asian refineries (ex-China) to reduce their purchases by around 200 to 300 kb/d. A hard exit would make these losses a Q4 2018 event, while a soft exit would push those reductions into H1 2019. Figure 1: Sanctions dates versus Iranian crude production Iranian Crude Production versus Sanctions Events (mb/d) 4,500 UN US EU JCPOA UK 4,000 CA 3,500 3,000 2,500 All values in USD unless otherwise noted. Priced as of prior trading day’s market 2,000 close, ET (unless otherwise stated). 1,500 For Required Conflicts Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Disclosures, please see Source: Petro-Logistics SA, news and government sources, RBC Capital Markets page 5. RBC Capital Markets appreciates your consideration in the 2018 Institutional Investor All-America Research Team survey. Disseminated: May 6, 2018 14:00ET; Produced: May 6, 2018 12:15ET Iran: Chain Reaction Figure 2: What did sanctions relief mean? Top Oil Buyers from Iran and Reductions (kb/d) Under the JCPOA, sanctions relief helped Iran economically in Pre-sanctions Sanctions JCPOA a number of ways. Specifically, it was able to reach around 7% Country/Bloc (2011 avg.) (Jan. 2014) (Jan. 2016 ) growth in 2016 and 2017, while also increasing its oil exports European Union 600 Negligible near 2011 back to near pre-sanction levels (currently around 2 mb/d). Under the deal, Iran has also been able to attract some new China 550 410 near 2011 foreign investment and was able to secure deals to purchase Japan 325 190 near 2011 aircraft (i.e. from Boeing and Airbus). These benefits paid India 320 190 near 2011 dividends for some of the more moderate politicians in Iran, South Korea 230 130 near 2011 for example, President Rouhani was arguably aided by the Turkey 200 120 near 2011 JCPOA in winning re-election in May 2017. That said, some South Africa 80 Negligible unclear within the country still contend that Iran did not receive the Malaysia 55 Negligible unclear promised economic dividends. Prior to the nuclear deal, the US Sri Lanka 35 Negligible unclear had imposed sanctions over 2012-2015 which proved Taiwan 35 10 small increase challenging. During that time span Iran’s crude oil exports fell by 1.4 mb/d to around 1.1 mb/d (down from approximately Signapore 20 Negligible unclear 2.5 mb/d previously), and its economy contracted by 9% on Other 55 Negligible small increase average each year. Over $120bln in reserves held at Total 2.5 mb/d 1.1 mb/d 2.4 mb/d international banks was also inaccessible. Source: Congressional Research Service, RBC Capital Markets Revoking sanctions waivers this week would finally end US participation in the landmark 2015 Iranian nuclear deal. By taking such action, President Trump would fulfill a key campaign promise and please key Middle Eastern allies as well as his increasingly hawkish foreign policy team. However, such a decision also entails some economic policy challenges in the form of potentially higher oil prices. The President’s recent twitter attack on OPEC can be seen as a sign that he is increasingly concerned about the political costs of rising gasoline prices. Hence, the timing of any sanctions snapback will be a critical policy decision for the White House. One option open to the administration is to adopt the Obama administration playbook of allowing a 180-day grace period before forcing foreign corporates to make “significant reductions” in their Iranian crude imports every six months. While the Congressional legislation never mandated a specific percentage for the required import reduction, the Obama White House used a 20% figure. If the Trump team adopts such a phased approach, that would push the actual reductions into H1 2019. An immediate reinstatement of the energy sanctions and the start of the 180-day import cut clock, in turn, would trigger a fairly sharp halt in Iranian crude purchases from consumers that seek to be compliant with US measures even if Trump opts to use the same 20% figure. While there is considerable debate over the effectiveness of unilateral US action on Iran, we think that a revival of the threat to lock non-compliant corporates out of US capital markets provides the White House with a pretty powerful stick. While Chinese compliance is probably a nonstarter, we do anticipate a high degree of cooperation from European, Japanese, and South Korean corporates despite their host government’s opposition to the US move. We would also point to the market reaction to the recent US sanctions targeting Rusal, as another indicator that such punitive measures can be enormously impactful even if they are unilateral. Filling the Gap Another critical contingency will be the role of Saudi Arabia in helping to fill the supply gap. Given the tightening fundamental backdrop, especially with the escalating Venezuelan production outages, the White House will likely look to its key Middle Eastern ally, Saudi Arabia, to help fill the supply gap and prevent a price spike. The Kingdom has certainly been a strong opponent of the JCPOA and has consistently pushed Washington to take a tougher line on Iran’s support for a host of regional extremist groups and armed proxies. The Saudi May 6, 2018 2 Iran: Chain Reaction leadership quickly (and enthusiastically) embraced President Trump, in no small part because they believed his arrival would end Obama’s rapprochement with Iran. However, Saudi’s willingness to put additional barrels on the market to assist Washington remains something of an open question. In 2012, the Kingdom publicly pledged to make up for any shortfall in exports from Iran and consulted closely with Washington on supply arrangements. This time around, Saudi Arabia seems more wedded to higher oil prices, as they provide the key enabling environment for many of the most important Vision 2030 reform measures. The Kingdom has gone from being one of the more dovish members of OPEC to being a preeminent hawk and cut enforcer. Despite subsidy cuts and the introduction of new taxes, the country’s fiscal needs appear to be climbing; with the IMF recently stating that Saudi's fiscal breakeven for oil has risen to $85-87/bbl (our 2018 estimate is $83/bbl). The Trump Administration may be hoping that Saudi barrels will be returning to the market anyways in 2019 with an anticipated sun setting of the OPEC cut agreement. With talk of an OPEC extension into 2019, still percolating despite the decent run up in prices, such optimism again may not be entirely justified. The Day After The Iranian response to a US withdrawal from the JCPOA will also warrant very close watching. The recent ramp up in Iranian exports is likely part of Tehran’s advance preparation for a sanctions snapback and an effort to secure the highest supply benchmark before percentage cuts are applied. In addition, the Iranian leadership will likely appeal to the Chinese to increase their purchases of Iranian barrels to make up for the losses to other markets.