Iran Sanctions (Special Series), Part 3
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I'm including a STRATFOR report that discusses the possibility of gasoline import sanctions against Iran. It's an absolute must-read for anyone interested in energy, foreign relations, Russia, the Middle East, etc. I'd encourage you to sign up for their free weekly reports here, so you aren't limited to what I send you on occasion. Begin (or continue) your journey to well-roundedness... Now, get to the line and practice your free throws.

John Mauldin
Editor, Outside the Box


Iran Sanctions (Special Series), Part 3: Preparing for the Worst

September 25, 2009

Summary

Iran has long been preparing itself for U.S.-led sanctions against gasoline imports and is confident in its ability to circumvent them. But even if the sanctions did get Iran's attention, they would not necessarily bring it to the negotiating table. Iran takes resistance very seriously, and while extolling the virtues of self-sacrifice it could close the Strait of Hormuz, which would wreak havoc on the global economy.

Editor's Note: This is part three of a three-part series on what sanctions against Iran could mean for Iran, U.S.-Russian relations, Israel and the global economy.

As the Iranian regime continued apace with its nuclear program, it understood that it was only a matter of time before the West would aim for its gasoline imports, a potential Achilles' heel for Iran. Although Iran may be one of the world's top-five crude-oil producers and exporters, its rogue reputation isn't exactly good for business. The Iranian energy industry has been sagging under the weight of sanctions for decades as the foreign energy majors with the technical skill Iran so badly needs wait for the geopolitical storm clouds to clear before tapping the country's vast energy reserves.

To contain domestic political dissent, the Iranian regime has heavily subsidized the population's energy needs. The drawback to such a policy is that ridiculously cheap gasoline prices (gasoline in Iran costs around 9 cents per liter) tend to fuel rapid consumption and rampant smuggling. As Iran's population continued to grow, so did its appetite for gasoline, and the regime has now reached a point where it simply cannot keep up with domestic demand without importing at least one-third of its fuel.

So, while Iran's Arab rivals, such as energy heavyweight Saudi Arabia, profited immensely from record-high crude prices in 2008, the Iranian regime was still struggling to balance its accounts. Then came the global economic collapse, which sliced the country's oil revenues in half. And given the sponsorship by the Islamic Revolutionary Guard Corps (IRGC) of militant and political proxies in Iraq and Lebanon, Iranian President Mahmoud Ahmadinejad's repeated raids on the country's rainy-day oil funds for his political campaigning, and funding for the Iranian nuclear program, Tehran does not have much cash to spare.

Unreliable Allies

Iran is not oblivious to its gasoline vulnerabilities, but it also isn't left without options should Washington become more aggressive with its sanctions campaign. As discussed in detail in part two of this series, Russia — for its own strategic reasons — has developed a contingency plan, most likely involving Russia's former Soviet surrogate, Turkmenistan, to cover the gasoline gap should Iran start experiencing shortfalls. The Russians are certainly not planning to do this out of the goodness of their hearts and sincere loyalty to their allies in Tehran. On the contrary, sabotaging Washington's sanctions regime against Tehran is yet another way Moscow can turn the screws on the United States if the Obama administration refuses to take seriously the Kremlin's demand that the West respect its influence in the former Soviet sphere. Since the Obama administration backed down recently from its Ballistic Missile Defense (BMD) plans in Central Europe, there could be more room for Russia and the United States to engage in serious negotiations. That said, there is no guarantee that Washington would be willing to pay the price of Russian hegemony in Eurasia in return for Russia's cooperation on Iran, and Moscow will drive a hard bargain before it even thinks about sacrificing its leverage with Iran.

Iran could certainly use Russia's help in maintaining its gasoline supply, but Tehran is also quite wary of becoming that much more dependent on Moscow's good graces for its energy security. Russia and Iran have quite a tumultuous history (the Soviets briefly occupied Iran during World War II), and the Iranian leadership is fearful of being abandoned by Russia should Moscow reach some sort of compromise with Washington.

Iran's other energy-producing ally hostile to the United States is Venezuela, which recently announced it would come to Iran's aid in the event of sanctions and supply its Persian friends with 20,000 barrels per day (bpd) of gasoline starting in October for an $800 million annual fee. Beneath the revolutionary rhetoric of oppressed regimes sticking it to their imperialist foes, this Venezuelan-Iranian energy deal is filled with holes. For starters, Venezuela — much like Iran — is facing serious refining problems due to mismanagement and a severe drop in foreign investment. Also like Iran, Venezuela's populist regime heavily subsidizes its constituents (gasoline in Venezuela is even cheaper than in Iran at 4 cents per liter), sending consumption soaring over the past four years. While Venezuela is currently refining around 420,000 bpd, it still needs to import gasoline to help meet domestic demand.

Caracas could always go through a third party to supply gasoline to Iran from a source closer to the Persian Gulf, but finding a willing supplier could prove difficult and costly when insurance premiums and political risks are taken into account. Moreover, should push come to shove, Washington has substantial leverage over the Venezuelan regime given the abundance of assets that Citgo, the refining unit of Venezuelan state oil company Petroleos de Venezuela, has spread throughout the United States. The United States also is the largest recipient of Venezuela's crude exports and one of the few markets in the world with the technological capabilities to process Venezuela's heavy crude, leaving Venezuela without much of a viable alternative market.

Iran has already turned to China to help backfill its gasoline supply. Latest estimates show that starting in September, China began to directly supply up to one-third of Iran's total gasoline imports. Until now, Chinese involvement in the gasoline trade had mostly been limited to shipping companies. In the run-up to the Oct. 1 talks, China now has the extra incentive to poke the United States and profit from these gasoline shipments to Iran. After having boosted its refining capacity this year, China has surplus gasoline to sell on the international market. In August alone China exported 140,000 barrels of gasoline per day. Like Malaysia's Petronas, which began supplying Iran with gasoline in August, China sees an opportunity to profit off of Iran's gasoline trade at a time when political tensions are rising and major energy firms, such as BP, Reliance and Total, have already stopped or are cutting back their shipments to Iran. But Iran may not be able to rely on Chinese aid over the long term.

China currently is in a heated trade spat with Washington over a recent U.S. tariff on Chinese tire imports and could push back against Washington even further by flouting the threatened sanctions regime. However, this is a decision with major strings attached. Washington still has a great deal of leverage over Beijing in the form of Section 421, a U.S. law that was incorporated into China's accession agreement with the World Trade Organization in 2001 and allows the United States to legally impose tariffs on nearly any Chinese export until 2013. Now that Obama has put Section 421 to use in restricting tire imports, the Chinese have to think twice before making any moves that could compel Washington to go even further in slapping trade restrictions on China. Additionally, China is a massive energy importer itself, so shipping any sort of energy product to the Middle East, where its supply lines are unprotected, is something that works directly against most of China's energy security strategies.

The United States has not yet formalized the gasoline sanctions against Iran in the form of legislation or a U.N. Security Council resolution, and this may be providing Beijing a limited opportunity to hit back at the United States during the trade spat and demonstrate the limits of Beijing's cooperation. However, Beijing will be far more cautious than Russia when it comes to blocking sanctions against Iran and will keep a close eye on Russia's intentions in deciding its next steps. China has long been noncommittal when it comes to sanctions against Iran and will align itself with Russia in forums like the U.N. Security Council to demonstrate its opposition to punitive U.S. economic measures. Of course, if Russia folds and reaches some sort of compromise with Washington, China will comply with the sanctions and avoid being left in the spotlight as the sole sanctions-buster allied with Iran.

In short, Iran has friends that it can turn to if necessary, but the reliability of those friends is by no means guaranteed.

Fending for Itself

In the spirit of self-sufficiency, Iran has long been preparing itself for a U.S.-led offensive against Iranian gasoline imports. Over the past two years, as talk of gasoline sanctions intensified, Iran sought out willing suppliers to help stockpile its gasoline reserves. Iranian gasoline consumption currently stands at around 300,000 to 400,000 bpd, but over the past several months, Iran has been importing well in excess of that amount from mostly Swiss suppliers and now newcomers like Malaysia's state-owned Petronas, which are looking to replace the energy majors that are dropping out of the Iranian gasoline trade while political tensions are high. Iranian and U.S. intelligence sources claim that Iran currently has at least three months worth of gasoline needs (estimates average around 30 million barrels) stockpiled. The director of the National Iranian Oil Refining and Distribution Company claims Iran's gasoline storage capacity is about 15.7 million barrels, which gives Iran about four months of in-storage capacity. Some of the surplus gasoline is sitting on tankers off Kharg Island, but the bulk of the supply is stored on land, where it is less vulnerable to airstrikes.

Iranian Gasoline Imports - 2009

The Iranian government continues to make bold claims about its ability to massively ramp up its refining capacity and become self-sufficient in gasoline production within four years, but this is mostly hot air. Iran simply doesn't have the capability to meet its gasoline production goals on its own without the necessary foreign investment. And even if Iran had willing partners in places like Central Asia, it would still need to overcome its extreme reluctance to actually foot the bill for such projects.

It may strike some as odd that Iran has acquired a capability to develop nuclear technology but still struggles to build and operate refineries on its own. There are a number of reasons for this, but the simple answer is that the technology for a nuclear program dates back to the 1930s and 1940s and has not changed much since, while refining technology is continually updated and Iran has been out of the global oil-and-gas mainstream for 30 years now. A nuclear weapons program requires a couple dozen or so highly trained scientists and engineers to operate it, and these personnel can be trained in any number of institutions around the world. On the other hand, a permanent staff for a refinery producing around 300,000 bpd would require some 1,200 highly trained technicians and petroleum engineers, and most of Iran's intelligentsia — particularly the group with strong technical skills — left the country following the Iranian Revolution. Iran's stated energy goals are full of delusion as well as ambition.

Confronting the Subsidy Problem

Iran thus has little choice but to figure out a way to reduce gasoline consumption at home. The Iranians started on this initiative in June 2007 when the regime implemented a rationing system. Though the move was extremely unpopular and instigated a spate of riots in Tehran, the backlash was swiftly contained and, according to energy industry sources, Iranian gasoline imports dropped from 40 percent of total domestic consumption to about 25 to 30 percent.

The next step is for the regime to start cutting untenable subsidy rates by raising the price of gasoline. This is a plan that has long been in the works but has been put off time and time again due to the regime's deep-rooted fear of sparking major social unrest. This especially became a concern following the June presidential election debacle, which gave scores of Iranian citizens the courage to pour into the streets to voice their dissent against Ahmadinejad. Though the protests have dramatically dwindled in size, they continue sporadically and are a persistent irritant to the regime. Iranian sources claim that the coming gasoline price hike will not be that dramatic in the beginning. The government would likely continue to subsidize domestically produced gasoline while allowing the cost of imported gasoline to rise so it can pass along a portion of the costs to the consumer and further dampen demand.

Besides the potential political fallout, there is another significant issue with this gasoline price-hike plan. Since gasoline prices are heavily subsidized in Iran and are, therefore, much cheaper than the gasoline sold in neighboring countries, Iran has a major problem with gasoline smuggling to these countries. Iranian sources claim that more than 750,000 barrels are smuggled every month from Iran to Turkey, Afghanistan and Iraq, and this puts a considerable drain on Iran's energy revenues. The smuggling rings are run by a variety of actors, from Iranian organized crime entities linked to the IRGC to Balochi tribesmen to Kurdish smugglers, and they are extremely difficult for the regime to dismantle. Moreover, Iranian officials tend to turn a blind eye to these smuggling practices in order to buy political patronage from non-Persian minorities (Kurds, Balochis and Azeris) in the borderlands who could otherwise cause serious trouble for the regime. With the political situation at home particularly dicey right now, the Iranian government will have to proceed cautiously with any future price hikes, which are sure to be applied unevenly across the country.

Natural Gas Relief?

Iran also has an alternative-fuel plan under way that capitalizes on the country's natural gas resources and reduces its reliance on refined crude, but the results have so far been limited. The plan involves encouraging the use of compressed natural gas (CNG) for Iranian motorists. Cars that can run on CNG, which are prevalent in South Asia and Latin America, can be more economical and environmentally friendly. In fact, the price of CNG retails at around 4 cents per cubic meter (roughly equivalent to one liter of gasoline). Moreover, the technology used to compress natural gas is far less complex than that needed to refine crude. Considering that Iran is the world's fourth-largest producer of natural gas, the switch to CNG makes sense, but there is one big drawback. Vehicles must be modified to run on CNG, and CNG stations would have to be built across the country. None of this would be quick or cheap for Iran.

Nevertheless, Iran has made notable progress since kicking off its CNG plan in 2007, when Iran Khodro Industrial Group — Iran's leading automaker — invested $50 million in low-consumption, flexible-fuel engine production lines. Former Iranian Oil Minister Gholam Hossein Nozari said in July that there are currently 880 CNG stations in Iran, with plans to build an additional 400 within the next several months. Since Iran Khodro started ramping up production of CNG-capable vehicles, Iran has become the world's fourth-largest CNG-vehicle producer following Argentina, Pakistan and Brazil, according to the International Association for Natural Gas Vehicles. As of May 2009, Iranian government officials claim the official count of CNG-capable vehicles on the road totaled 1.4 million. The total number of cars in Iran was estimated to be 11.7 million in 2008, according to the Global Market Information Database. All in all, estimated fuel replacement by CNG is currently around 7 percent of Iran's total automobile fuel consumption, up from zero five years ago. While Iran seems to be making steady progress in the CNG arena, it still has a way to go before the switch to CNG would make a significant dent in the country's gasoline imports.

Responding to Pressure

When STRATFOR speaks to Iranian sources, we get the sense that the regime is feeling fairly confident in its ability to slip the sanctions noose while continuing to work on its nuclear program, using the same rhetoric it has used for the past seven years to drag negotiations into a stalemate. This continued confidence may be due to the fact that the Iranians have yet to feel the pinch of Washington's quiet campaign against Iran's gasoline suppliers. Though the energy majors appear to be dropping out of the Iranian gasoline trade, the numbers we have seen indicate that Tehran is importing surplus amounts of gasoline in preparation for tougher days to come. However, should Iran fail to outmaneuver the P-5+1 come Oct. 1, those tougher days could arrive sooner than it thinks.

In the weeks and months ahead, Israel will likely determine whether Iran and the United States are headed for a collision course in the Persian Gulf. The Israelis were promised "crippling" sanctions against Iran by the Obama administration. If that promise goes unfulfilled, and the Iranians (as they are expected to do) refuse to freeze their enrichment activities, the Israelis are likely to turn to the military option and demand Washington's cooperation. Israel understands Russia's leverage over Iran — particularly its ability to arm the Iranians with critical defense systems and sabotage a gasoline sanctions regime — and would rather deal decisively with the Iranian nuclear issue while the program is still several steps away from a critical phase.

Israel, unlike the United States, never had much faith in the sanctions to begin with. The U.S. administration appears to be operating under the assumption that severe sanctions against Iran will create a dire economic situation in the country, galvanize the masses against the clerical elite and thus coerce the regime into making significant concessions on its nuclear program. More imaginative policymakers believe that such economic sanctions could build on the dissent that followed the election and produce a third front to challenge and topple the regime. But Tehran's actual actions are unlikely to mesh nicely with Washington's preferred perception of the regime's mindset. Iran — at least for now — has no intention of meeting the West's demands to curb its nuclear program and takes the idea of resistance very seriously.

A Doomsday Scenario

Israel is willing to see how the sanctions regime plays out, but it also knows that it has a limited menu of options. If the sanctions are blown apart with Russia's help, the Iranians will obviously feel little pressure to negotiate seriously and the Israelis will have to turn to alternative options. If the sanctions prove effective because of Russian cooperation, a U.S. willingness to risk trade spats to enforce the sanctions or a combination of the two, the Iranians will be left feeling extremely vulnerable. However, that vulnerability would not necessarily bring Iran to the negotiating table. On the contrary, the Iranians are more likely to turn increasingly insular and aggressive with their nuclear ambitions. While extolling the virtues of self-sacrifice for national solidarity, the Iranian regime would begin to seriously threaten to use its "real" nuclear option — closing the Strait of Hormuz with mines and its arsenal of anti-ship missiles.

This is an option of last resort for the Iranians, but if Tehran feels sufficiently threatened, either by sanctions or potential military strikes, it could wreak havoc on the global economy within a matter of hours.

Setting ablaze the Strait of Hormuz would undoubtedly inflict intense pain on the Iranian economy, but this may be a pain that the regime is willing to bear while it watches energy prices soar and the world's industrial powers plunge deeper into recession. At such a level of brinksmanship, the United States would have to seriously consider a military campaign to preempt an Iranian move to close the strait, providing Israel with an opportunity to strike at Iran's nuclear facilities. If the United States failed to act in time and Iran succeeded in mining this critical energy chokepoint, then the U.S. military would have to clear the strait. Either way, the Persian Gulf would become a war zone and the global ramifications would be immense.

This may be a doomsday scenario, but it is one of increasing credibility given that the main players — Iran, the United States, Russia and Israel — continue to raise the stakes in pursuing their respective national imperatives. A number of questions remain: Will the United States put its trade relations on the line and aggressively enforce sanctions? Will Russia go the extra mile for Tehran and bust the sanctions regime? Can the United States and Russia reach a strategic compromise that will leave Iran out in the cold? Has Israel's patience regarding Iranian diplomatic maneuvers run out? Will Iran resort to its real nuclear option and threaten the Strait of Hormuz?

STRATFOR does not know the answers, and neither do the main stakeholders in this saga. However, come Oct. 1 these stakeholders must begin making some critical decisions that could dramatically alter the geopolitical landscape.


Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 10-01-2009 2:36 PM by John Mauldin