As of May 2, any country buying oil from Iran runs the risk of incurring U.S. sanctions as the waivers granted by Washington to eight countries six months ago expired. Since pulling out of the nuclear agreement with the Islamic Republic in May 2018, the administration of President Donald J. Trump has been piling pressure on Tehran with the aim of choking the Iranian economy by depriving it of oil revenue and access to the international financial market. The announcement on April 22 by Secretary of State Mike Pompeo that the waivers would not be extended aims to drive Iranian oil exports down to zero. Whether the policy will succeed in bringing about the change in behavior by Iran that the United States says is the intent will play out in coming months. But the fallout from this hard-line policy is already being felt in the oil market.

The end to oil-import waivers comes just as OPEC and its non-OPEC allies, or OPEC+, were starting to enjoy the fruits of their oil production cut agreement. In the first week of April, benchmark Brent blend crude oil moved above $70 per barrel as the 24 oil producers showed a relatively high level of compliance with output reductions while unplanned outages in Venezuela and Libya further drained supply from a tightening market. Then, Trump sent the oil market into a spin, announcing that Saudi Arabia and the United Arab Emirates had agreed to increase oil production to make up for Iranian barrels.

Prices rose initially on April 22, trading at above $74/bbl, their highest level so far this year. But the spike didn’t last as Trump inserted himself into the oil debate. The price gains evaporated, and the market dipped even further when Trump said that he had called OPEC and told them to “bring them down.” It wasn’t exactly clear to whom he had spoken since the OPEC Secretariat in Vienna appeared to be unaware of any recent communication with the U.S. president. Still, the market reacted with a sell-off, shedding some of its earlier gains and by the end of the month, prices had retreated to just above $71/bbl.

Thrown off guard by Washington’s surprise announcement that the sanctions waivers would end in just days, the Saudi Arabian Ministry of Energy, Industry, and Mineral Resources scrambled to draft a quick response to try to calm markets already jittery at the prospect of losing at least 1 million barrels per day of Iranian oil. There are conflicting reports as to how much oil Iran is currently exporting with some suggesting that volumes are as high as 1.4 mb/d.

Saudis See No Need for Immediate Action

Saudi Minister of Energy, Industry, and Mineral Resources Khalid al-Falih said the kingdom, which has cut production below its allocated target, would “coordinate with fellow oil producers to ensure adequate supplies are available to consumers.” Two days later, presumably once the Saudis and other producers had time to digest the latest news out of Washington, Falih said he saw no need for immediate action because inventories were still rising despite the drop in Venezuelan production (partly due to U.S. sanctions and the current political crisis) as well as the punitive measures against Iran. There are geopolitical tensions in Algeria, where mass protests toppled its long-term leader Abdelaziz Bouteflika and senior officials accused of corruption. Oil and gas production have not been affected in the North African country, which is an OPEC member, but the continued protests and uncertainty have contributed to bullish sentiment in the oil market.

Prior to the announcement of the end to the sanctions waivers, Saudi Arabia appeared to be in favor of extending production cuts to the end of the year. However, now OPEC and its partners will likely proceed with caution given that they were wrong-footed in November 2018, when Washington reimposed sanctions on Iran and sprung a surprise by granting waivers to eight countries that purchase Iranian crude oil just as OPEC+ had increased its output in anticipation of a tighter market. Earlier in the year, the U.S. administration said it aimed to drive Iranian oil exports to zero as a way of putting pressure on Tehran to change its behavior and meet a series of demands. Washington backtracked as oil prices surged just ahead of the U.S. mid-term elections, a spike that Trump blamed on the Saudis and OPEC rather than on the United States’ Iran policy.

The OPEC+ Joint Ministerial Monitoring Committee is due to meet in Jeddah, Saudi Arabia, on May 19, when it will study the latest supply and demand numbers and come up with a recommendation for consideration by the full ministerial meeting in Vienna in June.

At risk from all these conflicting signals is not only more volatile oil prices but the fate of a hard-won agreement to get Russia and 10 other non-OPEC producers to trim output in order to balance markets and prop up prices. The agreement has succeeded somewhat in removing excess oil from the market and restoring balance after the turmoil of 2014 and 2015, when prices had slumped under the weight of oversupply and OPEC’s former policy of defending market share. The Saudis have made clear they want to see lower inventories in consuming countries.

Now, OPEC+ has to worry about a scenario in which some producers are unable due to capacity constraints to increase production while others like Saudi Arabia, the UAE, and Iraq, which have additional capacity, would benefit by taking some of Iran’s market share should the producers agree to raise output. It would be difficult for Nigeria, Angola, Algeria, and a handful of the smaller producers to raise output significantly. Already, Qatar has quit OPEC and Libya too considered leaving the producers’ group. Iran is predicting the death of OPEC as a result of U.S. policy.

Iranian Oil Minister Bijan Namdar Zanganeh, an OPEC veteran, said on May 1 that the use of oil as a weapon against two founding members of OPEC, referring to Iran and Venezuela, is “disturbing the unity of OPEC and creating the death and collapse of OPEC.” When ministers last met in Vienna in December 2018, Iran reportedly threatened to quit if it was not granted an exemption from the production cut agreement. Publicly, however, Iran has said that it does not plan to leave OPEC.

Russia too may find that aligning itself with Saudi Arabia and OPEC is not in its best interests if it means having to compete with the Saudis and others in OPEC for a larger share of the Asian market. Russia already supplies China, Iran’s biggest customer in Asia, by pipeline and could boost flows if needed. However, China, which had been granted a waiver in November 2018, has criticized the U.S. decision to scrap the exemptions, saying that the move could destabilize the Middle East. It is not yet clear whether Beijing, which is in the midst of difficult trade negotiations with Washington, will defy the threat of U.S. sanctions and continue to import Iranian oil. China was by far the biggest importer of Iranian oil in March (at around 550,000 b/d) followed closely by India (at around 400,000 b/d) and is very sensitive to price hikes. Replacing Iranian crude will be costly as the heavier types of crude oil produced by Gulf Arab states are now selling at a premium due to the production cuts. Iran has said it would defy the U.S. sanctions and continue to export oil but may find it difficult to find banks or refiners willing to risk U.S. sanctions for breaking the embargo. However, the zero target may prove elusive. OPEC insiders believe that some Iranian crude buyers may try to negotiate exemptions with the United States in return for some concessions on a case-by-case basis. They see some Iranian oil making it to markets with volumes somewhere between 300,000 b/d and 700,000 b/d. U.S. State Department officials have not said whether the United States would allow oil that was loaded before the sanctions waivers expired to be delivered to buyers.

Should OPEC+ determine that the market needs more oil in the second half of the year, it is unclear which of the 24 producers could supply the additional barrels and at what cost to market stability. Saudi Arabia holds roughly two-thirds of global available spare production capacity, estimated by the International Energy Agency at 3.3 mb/d in its April Oil Market Report. Increasing production would shrink this spare capacity and make for an even more volatile market.

Between them, Saudi Arabia and the UAE, which have supported and encouraged a more hard-line U.S. policy toward Iran, could easily make up for the lost Iranian barrels but to do so without a consensus agreement with their OPEC and non-OPEC partners would be counterproductive to the cohesion of the OPEC+ alliance and its ability to manage global supplies.

Saudis Sit on Bulk of Global Spare Capacity

Saudi Arabia could increase production from a current 9.8 mb/d to just over 11 mb/d as it did late in 2018, when it ramped up output in anticipation of lower Iranian exports before the United States granted the waivers. Total Saudi capacity currently stands at 12 mb/d, excluding its share of the Neutral Zone with Kuwait where output remains shut-in. The UAE could also push out an additional 250,000 b/d of extra crude. The United States also expects to increase production. Pompeo said on April 22 that the United States had added 1.6 mb/d to its oil output in 2018 and the U.S. Energy Information Administration expected an increase of around 1.5 mb/d in 2019.

Already, Iran has raised the stakes in declaring its intention to defy the sanctions though finding willing customers is another story. It has also repeated its threat to shut down the Strait of Hormuz, the most vital of the world’s oil chokepoints through which some 20 percent of the world’s tradable oil transits on its way to markets. For Iran, the strait is its only export outlet and closing it would make it impossible for the Islamic Republic to flout the sanctions. The United States has dismissed the threat as bombast. Iran has threatened repeatedly in the past to shut down the strait but has never taken any action to do so. Saudi Arabia and the UAE both have export outlets that bypass the Strait of Hormuz.

The Gulf Arab states most vulnerable to any disruption through the narrow strait are Iraq and Kuwait. Iraq, OPEC’s second largest producer, exports the bulk of its crude oil through its southern port of Basra. Its exports averaged 3.5 mb/d in February through March. Iraq imports natural gas from Iran because it lacks enough gas to run its power stations; Iraq suffers from lack of capacity due to war damage to its infrastructure. Washington granted a 90-day waiver for Iraq to import Iranian gas on March 19, although there is no guarantee that it will be renewed, which would leave Iraq at risk of blackouts at the start of the scorching summer season and with that the threat of social unrest.

In its effort to tame Iran by squeezing its main source of revenue, the United States has succeeded in seriously weakening the Iranian economy. The intention is to deprive Iran of the means to finance its proxies and its meddling in the affairs of states in the region. Pompeo said that before the sanctions came into effect, Iran generated as much as $50 billion annually in oil revenue, but the sanctions have deprived it of well north of $10 billion.

Iran is no stranger to sanctions and has managed to find ways to survive adversity in the past. International sanctions before it negotiated the nuclear deal with world powers in 2015 strengthened the hand of the hard-line factions and allowed the already powerful Islamic Revolutionary Guard Corps, now designated a terrorist organization by the United States, to become an omnipresent economic force in Iran. The recent appointment of a hard-liner, Brig. Gen. Hossein Salami, as the new commander of the IRGC, makes capitulation by Iran highly unlikely.

Predictably, backing Iran into a corner has raised tensions in the Middle East. This will add another layer of geopolitics into a volatile oil market, which could lead to a spike in oil prices in the months ahead. Zero barrels from Iran may prove to be an expensive gamble for the United States.