Iranian Revolution Ahead?

Jim Brown
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The news headlines were full of articles about problems in Iran and the potential for a regime change pushing the price of oil lower. Don't believe everything you see in the news.

The headlines out of Iran today were all about the implosion in their currency and skyrocketing inflation as a result of the sanctions. Reporters theorized we could see a quick regime change similar to that in the Arab Spring other countries in the Middle East. While that is possible it will not impact the price of oil in the near future.

First, President Admadinejad is not well liked by his own people. They would be thrilled if he left. However, he is NOT the government. He is just the puppet figurehead responsible for administering the wishes of the Supreme Leader.

The real regime in Iran is the Supreme Leader Ayatollah Ali Khamenei. He is the religious leader and the holder of all the power. He pulls Admadinejad's strings. Lately he has kept the president on a short leash because of his wild accusations, stupid remarks about Israel and the holocaust, and continually making a fool of himself.

The real outcome of this currency implosion in Iran is of course unknown BUT the supreme leader is not going anywhere. He is God's right hand to the Iranians. Fortunately he has said repeatedly that nuclear weapons are an abomination and it would be a sin to use one. But, talk is cheap.

The blowup this week was over the rapidly shrinking rial, the currency of Iran. In January 2011 it took 10,000 rials to buy a dollar. A week ago it took 24,000. Yesterday it took 37,500. That is a 40% increase in inflation in only a week. That means every item a citizen in Iran can buy went up 40% over the last week.

Regimes do fall when hyperinflation arrives. However, in a police state it would take a lot bigger problem to make it happen in a rapid fashion. The Iranian government said today it was going to eliminate foreign currency exchanges outside the government. That means all the currency traders will be put out of business and the rial will be the only currency. The minister of the economy said all the vendors were being closed and the "unofficial currency market will be gathered up." This "will lead to the elimination of the trickster's market."

The government claims this implosion in the rial is false and caused by fraudulent traders and manipulated by speculators. In the future only government offices will be allowed to convert currency "whenever there is a valid purpose." That can be translated as "never." Apparently if they don't allow trading in currency they believe they can assign any value they want to the rial. That has never worked in any currency in any country in the past. The black market always exists and reality has a way of asserting itself.

By Wednesday afternoon all the reputable Tehran based money traders had been shutdown., a Tehran based exchange, posted this message on its website: "To comply with the policies of the Central Bank of the Islamic Republic of Iran, and to help organize the currency market of Iran, Sarafi Jalali for now will not announce any rates. Subject to permission from the central bank, the announcement of a new rate will be made." Many other websites were no longer online. A message on the website of Mazanex, a site that provided real-time currency prices, said "Unfortunately access to this site and several similar websites has been closed."

Foreign traders contracted by Reuters in Dubai said they were no longer quoting the rial because contact with their counterparts in Tehran had been cutoff.

Iran announced last week they were severing links to Gmail because it allowed access to improper content from nations outside Iran. They also announced they were going to sever access to Google and transform the Internet into an Intranet where the only access would be to sites inside Iran or sites approved by the government. Apparently the transfer of uncensored information is getting to be a problem for the regime.

Clearly the sanctions against Iran are having an impact. However, even assuming Admadinejad was deposed tomorrow NOTHING would change regarding the sanctions. It would take many months for a change even if the new regime suddenly announced a halt to their uranium enrichment. Talk is cheap.

The Iranians have too much invested in the nuclear program. They have built it into a source of pride for the Iranian public that Iran can control its own nuclear future. Remember, the Iranian government is a pure propaganda machine. They continually brainwash the public to hate the great Satan and the Zionist pigs in Israel. By building up a common enemy it takes the public's attention off the problems at home. At least that is the theory and it has worked well in the past. However, seeing the price of a loaf of bread double in the last month goes a long way towards refocusing that hostility towards the government. The decades of propaganda will not go away overnight and you can bet the new president will come up with some new angle to cover over the current problems.

Unless conditions get a lot worse I would expect to see Admadinejad stay in power. He is already a lame duck with his term up in mid 2013. To kick him out of office early would give substance to the feelings there was something wrong with the regime. It would also empower the citizens to think they could cause even more change by using larger demonstrations. The Supreme Leader does not want the people to start feeling empowered.

So, if a regime change did occur and the new president said he would halt the nuclear program it would still take six months or longer for talks to be held and plans approved. The Iranian leaders have developed the political rope a dope into an art form. They can talk about nothing for years on the pretext of resolving a situation. They know by holding meeting after meeting and achieving nothing the other side will eventually tire of the effort. It has worked like a charm for the last three decades. I doubt that will have changed.

That means sanctions will not change for many months to come. The only way the UN, USA and EU has to hold their feet to the fire and force changes is with the sanctions. Once a deal was struck many months from now there would have to be verification put in place. The P5+1 nations have said repeatedly there would be no end to the sanctions until a halt in enrichment and shutdown of the Fordo plant could be verified.

So what does that mean for oil prices? It means Iranian oil will remain under sanctions until mid 2013 or longer. It means no change in production for Iran and no additional oil brought to market. The U.S. and EU are talking this week about another round of new sanctions and tightening up the existing sanctions. That means less oil will be sold to those still willing to buy from Iran. China and India are in the process of cutting back on purchases thanks to pressure by Hillary Clinton over the last month.

Let's assume a miracle occurs and sanctions were to be lifted by year end. The market would not change. Iran would sell another 1.0 mbpd and Saudi Arabia, Kuwait and the UAE would cut back on production by a similar amount. All three are producing at their upper limits and that stresses the fields and reduces future output. Slow and steady wins the race and right now they are in sprint mode.

The only thing that would change in the price/production structure would be a relaxation of the security premium. If Iran said it was halting the nuclear program then the threat of Israel attacking Iran would drop considerably. That would lower the current security premium in crude prices by as much as $10.

The drop today of -$3.50 may have been some of that security premium evaporating but unless something happens to the government of Iran in the next several days that premium will come right back whenever the next headline over the nuclear program comes out of Iran.

WTi Crude Price Chart

There is also the risk of a revolution inside Iran. You can only force feed the public so long before they reach a point where they won't take it anymore. When that happens, even in a police state, it becomes a revolution. In a police state where protesting can get you jailed or killed the method of protest can turn into vandalism and terrorist attacks. Guerilla warfare against the government is most effective when it takes place against critical government installations like oil facilities and refineries. That means there is a risk of production declining rather than increasing.

I believe it is far too early to be getting excited about the expectations for lower oil prices. One thing this drop in price did do was eliminate the potential for the U.S. to release oil from the strategic petroleum reserves (SPR). Even if President Obama wanted to announce a political release to reduce the burden of high gasoline prices he could not do it now. He may have gotten away with it a month ago but trying it today could be political suicide.

Lastly, if you have been a reader of this newsletter for the last couple months you know my price target for WTI crude was $88. I have been predicting a drop to that level for some time. There were several factors holding prices higher after Labor Day. Typical we see a seasonal decline after the holiday as demand slows. This year there was Hurricane Isaac shutting down production in the Gulf of Mexico and the violence across the Middle East and Northern Africa. The Israel/Iran security premium just added to that price support. The announcement of QE by the ECB and QE3 by the Fed also supported commodity prices.

I wrote last week that after Netanyahu speech at the UN that I believed the security premium was about to decline. In his speech he said the timetable for Iran to reach the red line of 90% capability for a bomb was 6-9 months out. That puts the potential for an attack well into 2013 and NOT before the U.S. elections as many had feared.

I believe the decline in oil prices to $88 today was simply accelerated profit taking as many of those factors listed above declined in intensity. We were expecting $88 but not necessarily in a single drop.

As energy traders we know that commodities take the stairs higher and the elevator down. Today was the express elevator. Traders also know that because of the futures component in crude we tend to overshoot on both the top and the bottom. Emotions turn from concern into panic when contract declines turn into crashes.

We have been looking for a return to $88 as a buying opportunity. I would be crazy if I did not tell you the events in Iran did not have me second guessing which support level will hold. Remember, we did trade under $80 just three months ago. Nothing says we can't trade there again. After today's big decline and the Iranian news it would probably be wise to watch Thursday's events before backing up the truck on equities.

Weekly Inventory Update

The EIA reported oil inventories that fell -500,000 barrels the prior week compared to estimates for a 1.5 million barrel gain. The decline came as a result of an increase in crude demand of roughly 405,000 bpd thanks to a rise in refinery utilization from 87.4% to 88.2%. Production and inventories appear to have finally level out after the three weeks of fluctuations after Hurricane Isaac.

Inventory Snapshot

U.S. production rose to a 16 year high at 6.52 mbpd. December 1996 was the last time the U.S. produced more oil per day. The EIA estimates that U.S. production could increase by more than 1.2 mbpd by January 2014 thanks to shale production in North Dakota and Texas. Larger capacity pipelines from the shale fields to the Gulf should be completed by then and landlocked WTI should rise in price to something closer to Brent prices.

With crude inventory levels already above the five year range the increase in crude production coupled with the lower demand over the next six weeks should keep a lid on prices.

Crude Oil Inventory Chart

Gasoline inventories rose only +100,000 barrels and gasoline demand declined by -140,000 bpd. This is a seasonal decline between summer vacations and holiday travel. We should start to see inventories rise towards the middle of the five year range. However, with the permanent shutdown of the refinery in the Virgin Islands and plants on the East Coast the buildup should be less than normal. With those refineries dropping out of the system we will start to build a new five year inventory pattern. With our gas prices high we should also see a pickup in imports to offset the loss of capacity.

Gasoline prices should begin to fall sharply thanks to the fall in oil prices and the switchover from summer blends to the cheaper winter blends.

Gasoline Inventory Chart

Distillate inventories declined by -3.7 million barrels. This was a surprise but forecasts for a colder winter in the Northeast may have spurred a sharp increase in demand for heating oil. Customers were waiting for the normal post Labor Day decline in prices but the arrival of cold weather meant putting off a fill up was no longer an option. Diesel, less than 15 ppm, declined sharply as well.

Distillate imports also declined about -50,000 bpd but that only amounts to 350,000 barrels for the week.

Distillate Inventory Chart

The EIA is projecting the three major shale production areas to experience a production boom in 2013. The Bakken (Williston Basin) has grown from 190,000 bpd in 2009 to 675,000 bpd in July 2012. They expect that to increase to 1.1 mbpd by January 2014.

Texas has increased oil production from 770,000 in January 2009 to 1.9 mbpd in July. The Permian Basin is expected to increase to 1.55 mbpd and the Western Gulf Basin to rise to 930,000 bpd (2.475 mbpd total) by January 2014.

The number of rigs drilling for oil has increased from 801 in February 2011 to 1,409 in September.

EIA Shale Oil Production Forecast

The rise in production across the U.S. shale basins is encouraging because that means less imports will be required. However, because of the stagnant economy the U.S. is currently using almost 2.0 mbpd less oil than in 2008. If the economy were to resume strong growth that two million barrels of additional supply would quickly be consumed.

Also, the depletion rate of older wells in North America is roughly 500,000 bpd per year. That means we are losing 500,000 bpd in older production as the wells run dry and are plugged. Currently the new production is outpacing this depletion rate but that is a function of the number of new wells coming online. New shale wells can have initial production for the first 30-60 days of 2,000 bpd but then it declines rapidly, depending on the basin to several hundred barrels per day. The current bounce in production is benefitting from the large number of new wells being completed each month.

Production from all U.S. Sources

My initial target for WTI was $88. I would expect this dip to support would see some bargain hunters appear but we need to see what happens in Iran through the weekend. Those are typically the busiest days of the week for demonstrations. While any real changes would take months to play out, the "perception" of future changes could play out in the price of WTI over the next couple of days before reality returns to expectations.

Jim Brown

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