Iran Deal Done - "Stunning, Historic Mistake" Or "Profoundly Positive Change"

While slightly later than expected, a comprehensive deal on Iran’s nuclear weapons program has now been reached. As Reuters reports, the agreement will be greeted with alarm in several quarters, both in Washington and Tehran and internationally too, and could yet unravel. Internationally, the deal will accelerate unease in some Arab states, including Saudi Arabia, but it is Israeli Prime Minister Benjamin Netanyahu who remains the fiercest public critic and has issued a warning that the accord will "inevitably lead to a nuclear war." The deal profoundly changes the balance of power in the region, but averts the conflict that was likely otherwise, but as ECStrat notes, Iran offers exceptional investment opportunities, but the near term impact will be to continue oil’s decline back to its lows, potentially taking energy stocks with it.


As Reuters notes,

The agreement will be greeted with alarm in several quarters, both in Washington and Tehran and internationally too, and could yet unravel. Internationally, the deal will accelerate unease in some Arab states, including Saudi Arabia, but it is Israeli Prime Minister Benjamin Netanyahu who remains the fiercest public critic and has issued a warning that the accord will “inevitably lead to a nuclear war.”


To be sure, no lasting settlement that Iran would ever be likely to agree to will completely eliminate its ability to build a nuclear bomb. In testimony last year, Kerry told Congress that it would, in theory, currently take Tehran around “two months” to produce sufficient nuclear material for such a weapon.


However, buttressed by greater international monitoring and oversight of Iran’s program, the P5+1 believe that they have significantly lengthened this so-called ‘break-out period’ to at least 12 months. This is a very sensitive issue with many conservatives in Tehran, including Supreme Leader Ayatollah Ali Khamenei.


This underlines the fact that, within Iran and the United States, opposition to a final deal is concentrated largely (but by no means exclusively rests) amongst conservatives, including the Republican Party which controls Congress. And, it is the American federal legislature where the deal faces the most obvious and immediate challenge, with a 60 day review period soon underway with final votes probably not until the autumn.

And John Boehner came out firing this morning...


However, as ECStrat's Emad Mostique notes, there are positives (and opportunities) from the deal...

While slightly later than expected, a comprehensive deal on Iran’s nuclear weapons program has now been reached. We think this is a good deal that stops nuclear breakout, the primary aim.

The deal profoundly changes the balance of power in the region, but averts the conflict that was likely otherwise.

We have been of the opinion that Iran’s nuclear program was primarily a defensive deterrent for a pariah, autarchic state, with any offensive function circumscribed by the jurisprudential foundations of Twelver Shia Islam (see page 6 onwards here).

Iran offers exceptional investment opportunities, but the near term impact will be to continue oil’s decline back to its lows, potentially taking energy stocks with it.

Pariah no longer?

The mutual distrust between Iran and the rest of the world stemmed from their outcast status that started after the Iranian revolution in 1979, when Iran had its own “Arab Spring”, overthrowing the monarchy for a democratic system that was then handed over to the control of Ayatollah Khomenei, who pushed a new concept of velayat-e-faqih, “guardianship of the jurists”. The unpredictable nature of the new, non-autocratic Iran led to most of the world uniting behind Arab leader Saddam Hussein in the horrible Iran-Iraq war that ensued, with only Israel providing substantive support to Iran as they were unsure Saddam was quite all there.

In the decades since there has been some degree of hesistance and debate in the West and Israel as to whether Iran was a state or an ideology (with the pejorative use of “mullahs” to refer to its leadership). As the former, one could treat it as a rational actor with various power blocs within it, as the latter the tendency was, to quote Benjamin Netanyahu who used a nuclear Iran as a key political canard, to view it as an “messianic apocalyptic cult”, particularly given Ahmadinejad’s tendency to make millenarian declarations of the return of the Mahdi.

The last few years of negotiation following the freezing of Iran from the global system in 2012, co-ordinated with several regional allies to try to prevent the inexorable shift in the regional balance of power and baking of the Shia croissant, has shown that Iran is indeed a rational state, albeit one with irrational actors within it.

These irrational actors were, as in many countries, primarily driven not by religious fervour, but rather by political ideology (rather conservative) and the desire to maintain their privileged status in society – Iran’s elite controlled the reins to the sanctions economy and thus became inordinately wealthy from it, even as the middle classes suffered.

The role of religion in the purported Sunni-Shia Cold War in the region has been overplayed and is primarily only a small contributory factor on the basis of cultural prejudices. This can be seen by historically well-integrated societies such as Iraq pre-war and Kuwait today, but external actors such as ISIS are adept at driving and widening sectarian wedges, building on some of the more aggressive interpretations of religion (an interesting exercise is to see how references to Shia shift from rafidi (rejectors of faith) to ajam (persian) in Gulf media).

Economic factors to political sanctions

Indeed, the erosion of the middle class and “bazaaris” was one of the most interesting elements of the recent sanctions regime, as this group had benefited dramatically from the easy monetary policy in Iran under President Ahmadinejad, who set real interest rates to -10% in a populist binge, causing a huge boom in the monetary supply base (almost four-fold pop) even as the currency was pegged to the dollar, resulting in a hugely overvalued rial and Iranian cash flooding the region and doubling imports into the Arab Spring to nearly $80bn.

This, combined with Iran undergoing subsidy reform (moving from $100bn a year on a $350bn economy to a basic income model) and GDP approaching $400bn made Iran a real threat from a soft-power basis in the region, particularly given its traditional “role” as supporting self-declared revolutionary groups such as Hamas and Hezbollah.

When sanctions kicked in in 2012, the Iranian rial simply corrected back to its real effective exchange rate, not a hyper inflationary collapse that some were warning of at the time. The currency has remained relatively stable in an EM context at around 30,000  with interest rates at 20% and the Rouhani government steadily reducing inflation down to 15% from over 40% (be careful when analysing Iranian economic stats as the years are a bit funny, as are some of the official calculations).

This move in the currency, which the elite could circumvent, halved imports and ironically crushed the increasingly influential middle class, who were effectively frozen out of the international market by SWIFT/banking sanctions. Indeed, the banking sanctions were the main spanner in the works for Iranian industry, as many industries were untouched by other sanctions but business just became too difficult to do for many others, particularly if focused on trade.

Recent sanctions and government action has led to some oddities in the Iranian economy in recent years, such as the savings rate dropping from 45% to 33% in the last few years with investment being squeezed, even as household consumption increased almost 10% to 52%. Real estate and luxury cars (particularly Porsches, which are oddly prevalent in Tehran) benefitted with imports at a quarter of consumption, but there is a significant gap in SME financing in particular.

While Iran will likely have access to over $100bn in frozen offshore reserves and assets, as well as 30m barrels of floating oil and increased oil flows, it faces a delicate balancing act if it is to avoid stoking inflation ahead of next year’s elections. The economy is moderately well diversified versus regional peers, with oil receipts under a third of GDP (with most of the receipts going on remaining energy subsidies and new social payments), but there is an increasing focus on economic diversification, with startup growth and accelerators actively encouraged and FDI, which currently stands at 2% of GDP, a key target. The opening of Iran should also change the political balance of power profoundly as the middle classes, who actually (mostly) pay tax, become the primary beneficiaries of increased trade and a reversal in declining investment.

Possibly the most interesting stock market in the world

The Tehran Stock Exchange has a market cap of $100bn and trades up to $200m a day, high in a frontier market context with a PE of around 6x and double digit dividends. Access should SWIFT sanctions be removed is surprisingly easy, but navigating the market is a bit harder as local knowledge is needed to separate the privately owned and controlled companies from those controlled by groups such as the Setad under Ayatollah Khamenei or under one of the myriad companies controlled by the praetorian guard of Iran, the IRGC. The bond market is nascent, but Shariah-compliant and growing

The stock market will be an essential means for Iran to encourage foreign investment and increase its profile, particularly as there are another potential $100bn of privatisations in the pipeline if current plans are kept to, ideally for the government at a higher valuation to the ones we’ve seen. We would expect inflows to be slower than one might think as foreign companies will be cautious of the web of sanctions that needs to be unravelled and many lack expertise in the region sufficient to navigate the opaque on the ground environment where corporate governance can be variable to say the least. The banking sector also doesn’t appear to be very healthy after years of economic mismanagement, but capital may suddenly become considerably cheaper to paper over the cracks

Gradual sanctions removal

Back to the Iran deal, per the proposed text sanctions removal looks to be gradated but reasonably comprehensive, with the key banking sanctions being removed with IAEA verification, the major fillip to the economy that will allow it to resume its growth.

Certain sanctions focused on human rights abuses and related to Iran as a state sponsor of terror will stay in place, but the initial range of removed sanctions seems surprisingly broad. Iran has much more work to do to become a valued member of the global community, but trade goes a long way toward that.

The most aggressive US sanctions have been codified by Congress and thus can only be waived by Congressional vote or waived on a short-term basis by presidential waiver. We don’t see this as being rolled back by future administrations, particularly as the likelihood of Iran adhering to the deal under our model is very high

Oil cracking

We have been firmly negative on oil for the last few months and continue to see a double bottom in the oil price as the near term impact of floating Iranian barrels and medium term impact of increased Iranian production (we would venture 700kbpd in 6-12 months and potential output of 4.5-5mbpd in a few years vs a prior peak of 6mbpd) is absorbed by the market, pushing down the curve over the next year out even as inventory build continues and we are a month or two away from US production falling.

It is worth noting that Iranian oil is fairly low cost and the current outline of new production sharing agreements looks attractive, so this is oil that is highly likely to come to the market versus higher cost fields elsewhere. Iran has proved oil reserves of 160n barrels, 10% of the global total and the worlds largest proved gas reserves at 34 tr cubic metres (18% of global total). Not all Iranian crude will be exported however as it already consumes 2mbpd a day and sanctions removal will allow it to diversify downstream, with the bulk of production increase occurring in 2018-2020.

We also note that, unlikely the end of last year when Saudi was actually cutting exports and not really being that aggressive on pricing differentials, they have, as expected, ramped up oil production to record levels and actually reduced internal consumption on a seasonally adjusted basis, as well as slashed prices going into this summer, trying to drive down prices at a critical time. This has been a key driver of recent weakness in the price, as well as the market factoring in returning Iranian oil.

OPEC won’t cut in line and our view on China remains firmly bearish (note they’ve also filled their strategic reserves, removing up to 200kbpd of “demand”), with all signs pointing to a double bottom in the oil price.

After that our viewpoints diverge, with my view being that we work through the inventory overhang to the end of this year as oil sold forward comes back to the market and geopolitics looks somewhat troubling into 2016, even as production peaks and falls due to lack of exploration spending and cash run off, pushing up the back end of the oil curve and seeing a return to backwardation taking us back up above $100 into 2017.

JP thinks we are in a new normal and the end of the Chinese boom and increased fuel efficiency means we could go even lower than the lows.

Market impact

Shall be interesting to find out, but a double dip will put real pressure on energy equities, maybe even on the magical CNOOC and Sinopec (!) which have divorced from reality on the China equity boom. Global energy stocks have largely been tracking 12m oil and this is the key gauge to look at as the market prices forward Iranian crude.

Elsewhere, this is terrible news for Nigeria, where the Buhari government has been slow out of the blocks in getting the new cabinet and leadership team in place. A devaluation to 240-250 over the summer is highly likely, even as subsidies are removed, placing a lot of pain on the locals. The only reason it seems to feel bullish is because suddenly everyone is so bearish on Nigeria, but valuations still don’t quite give the comfort one would require here as the post-Buhari pop has slowly punctured.

On a single stock level, concerns over Nigeria may be outweighing the positive impact of potential repatriation of Iranian profits for MTN, which has had a subdued reaction today. In contrast, Gubre, a Turkish fertilizer stock we have highlighted in the past as having a substantial portion of its EBITDA from Iran, is up 10% (looking expensive) and Savola, which has a solid portion of its edible oils business in Iran is also up a couple of percent.

Russia should also suffer from the Iranian deal short-term as can be seen by the Ruble reaction, but this is predictable given the high correlation one should expect between the currency and the oil price. Please see our latest governments and markets piece for our latest views on the overall market.

The Gulf nations face somewhat of a mixed bag as there are undeniably proxy conflicts in certain areas, such as Yemen (where the Shia influence is overstated), yet alliances in others such as the fight against ISIS. The Gulf stock markets will likely remain secure as the governments have shown they will continue spending, although the question now is whether and in what form they will finance potential deficits. Certain regional companies such as Savola may well benefit from their Iranian ties and as Iran opens it provides an attractive new market to cash rich Gulf companies in need of a population to sell to, particularly as North Africa looks increasingly dicey.

Geopolitical fallout

On a military basis fears of a regional Iranian hegemon are overblown, with the Iranian army likely continuing a defensive posture, even as it supports regional allies.

The support of regional allies is not a case of Iran being “evil” and supporting “evil”, but rather the quite rational policy of supporting those who share commonalities in political position and goals. The level of support also varies dramatically, from heavy support for Assad and the Iraqi government (where a delicate dance is playing out) to minimal support for the Houthis in Yemen, which looks like it is headed toward becoming Al Qaedastan as the death toll rises above that of the Gaza offensive last year and the sheer scale of emergency aid requirements is mind boggling but largely ignored.

None of these pose a threat to regional governments territorially, certainly compared to the threat of ISIS and Iranian military spending is unlikely to ramp considerably as the IRGC concentrate on maintaining internal power under a new political and economic reality.

To put this in context, Iran spends just slightly more on its army than Oman

This is not particularly good for President Netanyahu in Israel and may drive further wedges in the political process there as a key “immediate” threat has been largely neutralised. Long-term there is the possibility that this is a bad deal for Israel as he says, but it is difficult to get people to rally around long-term, with short-term domestic issues now likely to dominate. We think this is good for Israel’s safety.

Geopolitically this deal is great for Russia as it fits in with their theme of moving in to occupy the space left by the USA as it pivots from the Middle East to Asia.

We should expect a significant pickup in trade between Russia and Iran, with Turkey and China being the other major beneficiaries in this regard as the petrodollar nexus moves further East.

This also marks a massive success for President Obama and paves the way for an increased focus on Asia, where the rebalancing of China and Japan pose an uncomfortable problem with no clear solution.

It is unlikely that the next President will roll back a nuclear deal or stop extending waivers regardless of the current rhetoric. The exception would be if Donald Trump wins, but that opens up a whole new barrel of worms.

Congress will have 60 days to look at the deal but ultimately can’t block it. Big Oil will also lobby aggressively for the deal to be put in place.

The ultimate upshot of the deal however is peace as we avoid a distrous regional conflict.

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This political discontent in the United States may only embolden Netanyahu...


Especially with the latter’s new electoral mandate, Israel will probably reserve the right to take unilateral military action against Iran’s nuclear facilities.

Taken overall, the final, comprehensive nuclear deal is a historic landmark that opens a new chapter in Iran’s relations with the United States, and wider West. However, domestic and international critics will now rally against the agreement, and it will face an early and significant hurdle this autumn in Congress.