US and Iran strike a deal - What’s next?
US-Iran deal reduces downside risks, but many challenges remain
The US and Iran have reached an agreement to extend their ceasefire by 60 days and to restart shipping through the Strait of Hormuz – with Iran set to de-mine and refrain from attacking vessels, and the US dropping its naval blockade of Iranian energy shipments. The deal is set to be formally signed this coming Friday, at which point we should see a meaningful increase in flows through the Strait. The deal did not come as a surprise – with indications that we have been close to a deal already for much of the past month – but it does come as a relief given the various skirmishes that have tested the ceasefire recently. Still, the deal is in line with our most recent base case update on 27 May, which hinged on the Strait re-opening within weeks. Overall, we judge that the deal reduces the downside risks and the probability of more negative scenarios materialising, but we continue to think the current relief in energy markets will not be sustained, and that energy markets will remain fundamentally tight over the coming months.
How durable is the deal, and what comes next?
We said back in our March Global Monthly that it ‘takes three to TACO’, i.e. that the Hormuz closure is not just a matter for the US and Iran, and one of our main concerns continues to be that Israel is not part of the deal, despite it being a crucial actor in developments. Events just this weekend illustrate how fragile the deal is likely to be. Also challenging is what comes after the 60 day truce extension. Many sticking points need to be resolved between the US and Iran, such as the length of any moratorium on uranium enrichment, the costs of reconstruction in Iran (potentially tied to Iran's demands for sanctions relief and the release of frozen foreign assets), and the fact that it still wishes to levy tolls on the Strait of Hormuz (together with Oman). It would be no surprise if the Strait were to be closed again or a low level conflict were to resume if talks do not go well, or if Israel resumes its offensive in Lebanon.
Energy prices likely to bounce back after initial relief drop
Energy prices had already been falling in anticipation of the deal announcement, and have naturally fallen even further since, with Brent crude hitting a 3 month low of $82 per barrel at the time of writing. We do not expect these low prices to be sustained, for four reasons. First, the re-opening of Hormuz is expected to be gradual at first, with shippers and insurers likely to be cautious until they can be sure of the durability of any deal and the safety of passage. Second, oil production will also take time to normalise, as up to a third of wells are shut in, and a significant number of them will take months to be fully up and running again. Third, there has been considerable damage to energy (and reportedly shipping) infrastructure, especially to LNG and refining facilities. Finally, inventories have been run down sharply to extremely low levels, and there will likely be eagerness to restore these given that any deal could prove initially fragile. All of this is against the backdrop of peak summer demand. Taken together, while energy prices are currently falling, we expect prices to bounce back again given that the supply relative to demand is likely to remain tight probably at least for the remainder of the year.
We stick to our base case, while acknowledging risks to our view
Given the risks to the deal, the likely slow resumption of energy flows, and the need to rebuild inventories, we maintain our view that following the initial relief, energy prices are likely to bounce back higher, and that this will keep inflation well above central bank targets in advanced economies. This is expected to lead to two additional ECB rate hikes in September and December, according to our updated view, with the Fed and BoE expected to stay on hold given that rates are already in restrictive territory in the US and UK. Meanwhile, the impact on economic growth of a USD 10-20 deviation in oil prices is in any case moderate.
As well as the negative risks already discussed (i.e. the fragility of the deal), we also acknowledge that there are some positive risks (negative for oil prices) to our view. China has reacted to the gap in oil imports by restricting exports of oil products to Asia, leaning modestly on its commercial oil reserves, and reducing oil refinery output, but there has also been a notable change in behaviour, for example a switch from flying to driving with EVs. If this change in behaviour is more structural and accelerated, China may import considerably less oil in the future. Moreover, while our base case is for a gradual Hormuz reopening, there is also a risk that the exit of 300 or so tankers trapped in the Gulf that are currently laden with oil could result in higher supply in the short term and put additional downward pressure on prices. However, we also note that the lower supply from the Gulf for more than 100 days far exceeds the impact of a short-term increase in energy supply from trapped tankers. (Bill Diviney & Georgette Boele)