What does the Iran deal mean for the energy sector?
31 Jul 2015
By Shadforth Financial Group
After many years of negotiations, Iran and six major world powers – the US, China, the UK, Russia, France and Germany – have agreed on a nuclear deal.
The new deal will see sanctions imposed on Iran by the US, the European Union and the United Nations lifted in return for Iran agreeing to restrict its nuclear program. One of the key outcomes of this deal will see Iran resume its exportation of oil.
Figure 1: Timeline of Iran's sanctions
Source: US Energy Information Administration, WSJ
What does this mean for oil markets? The oil markets have had a mixed response to the Iran deal, with prices initially being weak before bouncing back. This is likely due to investors realising that the deal still needs to be ratified and that, more importantly, it will take Iran until 2016 to ramp up their oil exports again, for example reinvestment in infrastructure. In our view, oil prices are likely to remain under pressure in the medium-term as the demand and supply equation remains unbalanced. We already know OPEC members, led by Saudi Arabia, remain steadfast in retaining market share. Additionally, an official from the National Iranian Oil Company was quoted as saying, 'We will try to maximize our crude export capacity to Europe and restore 42 to 43 percent share in the European market before the sanctions were imposed.' Iran makes up 8.9 per cent of OPEC production (Figure 2) and the OPEC block (Figure 3) continues to produce above its own stated quota.
Figure 2: OPEC Member Breakdown
Source: Bloomberg, IEA
Figure 3: OPEC Monthly Crude Production
Source: Bloomberg, IEA
Oil supply. Among the main drivers of the oversupply in global oil prices has been the significant increase in production out of the US on the back of the unconventional shale oil revolution. On average, US oil producers are higher up the supply cost curve versus their Middle East counterparts and on average require oil prices to be around US$90 per barrel to be viable. The lower oil prices are starting to impact new exploration activity in the US. We are seeing the US crude oil rig counts declining in response to lower oil prices, indicating oil producers are putting exploration activity on hold in the current environment.
Oil demand. While oil producers are feeling the pinch, the flip side of lower oil prices is the positive impact they have on consumers globally. Lower share of wallet on fuel means consumers have increased propensity to spend on consumption, which also has a flow on impact on consumer sentiment. For example, in Australia lower oil prices could have a positive impact in the range of 1 per cent to 1.5 per cent on GDP. Similar numbers can also be said of China, Japan and Europe. Further, it also reduces the pressure on inflation, which will likely see interest rates remain accommodative.
What does it mean for energy stocks? We expect oil prices to remain subdued in the medium term. Energy equities – Santos, Oil Search, Woodside and Origin Energy – have taken a significant hit to their share prices over the last 12 months. In the current environment, investor focus has turned to balance sheets, capital expenditure plans and the viability of current projects. Most companies have already responded to the lower oil prices by tightening their capital expenditure and taking costs out of their business where possible. This leaves balance sheets as the key focus. There may be a further downside if investors begin to use oil spot prices in their valuations as opposed to the forward yield curve. The forward oil price expectation in our free cash flow forecasts is still well above the current spot price. Our view, which is in line with consensus, is that while the short term price (spot price) may continue to be weak for a period of time, it is expected to rebound to the global average marginal cost of supply of approximately US$85 per barrel.
Figure 4: Forward Oil Price Curve
Source: Oil Search presentation