Iran Nuclear Deal Bearish For Energy ETFs

Iranian oil exports could rise ‘within months’ to presanctions levels.

A historic nuclear accord between Iran and world powers sent oil prices briefly reeling on Tuesday. Prices for benchmark West Texas Intermediate (WTI) fell as low as $50.88 before rebounding to trade flat on the session.

The deal, which was 20 months in the making, promises to lift sanctions that include an oil embargo on Iran in exchange for limiting the country's nuclear capabilities.

Iran's Part
For its part, Iran must “reduce its stockpile of uranium by 98 percent ... and keep its level of uranium enrichment at 3.67 percent―significantly below the enrichment level needed to create a bomb,” according to a report on the White House website.

At the same time, the country has agreed to reduce its number of centrifuges by almost 70 percent from current levels near 20,000. Iran would need “tens of thousands of centrifuges to create highly enriched uranium for a bomb,” said the report.

Thirdly, Iran will redesign the heavy-water nuclear reactor at the Arak site so it cannot produce weapons-grade plutonium, cutting off the third way it could potentially build a bomb.

Making sure that Iran follows through on its end of the deal, inspectors from the International Atomic Energy Agency (IAEA) will monitor “every element” of the country’s nuclear program.

“If IAEA inspectors become aware of a suspicious location, Iran has agreed to ... allow inspectors to access and inspect any site they deem suspicious,” assured the White House.

The End Of Sanctions
Once IAEA inspectors are confident that Iran has begun to dismantle its nuclear infrastructure―likely by the end of the year―most of the financial and economic sanctions on the country will be lifted. However, sanctions on weapons trade may last for several more years, and broad-based sanctions may be reinstated at any time should Iran fail to uphold its end of the bargain.

One area where Iran has been desperate to see sanctions relief is the oil industry. The country’s production has been crippled by the combined embargoes of Europe and the United States. Iranian officials hope that once sanctions are officially lifted, exports can be ramped up quickly, potentially by as much as 1.2 million barrels per day.

Data from the Energy Information Administration show that Iran’s exports are almost half their presanctions levels from 2011. In 2014, the country exported 1.4 million barrels per day of crude, down from 2.6 million barrels per day three years prior.

“We hope that we can increase our exports to international markets,” Iran’s Oil Minister Bijan Zangeneh recently said. “We want to raise our exports within a few months to the level that we had before the sanctions."

Analysts have also added that Iran has 20 million to 40 million barrels of oil stored at sea that could be dumped on the market once sanctions are lifted.

Oil Price Action
Based on today’s news, one may have expected a much bigger, negative reaction in oil markets, but prices are close to unchanged on the session.

Crude Oil

Source Bloomberg

One interpretation of this price action is that traders are somewhat skeptical that a big wave of Iranian crude will be hitting the market anytime soon. Perhaps they believe that the hardliners in Iran or the U.S. Congress may end up scuttling the nuclear deal.

On the other hand, if one considers oil prices were already down about 15 percent this month heading into today, then perhaps this is a case where the bad news was already priced into the market. With negotiations going on for months, it wasn't necessarily a surprise to traders that a deal finally got done.

That's not to say prices won’t go even lower. Surprisingly resilient U.S. production, which remains stubbornly at multidecade highs, record-breaking Saudi oil output and bloated global inventories were already pressuring oil. The addition of hundreds of thousands of barrels per day of additional Iranian crude isn’t something the market can easily absorb.

Thus, it wouldn't be surprising to see oil dip into the $40s again at some point, perhaps even revisiting the low from March at $42.

Energy ETFs Hit
Such a scenario would certainly be a negative for energy sector ETFs. The most obvious losers are crude-oil-linked funds such as the United States Oil Fund (USO | B-100), the iPath S&P GSCI Crude Oil Total Return ETN (OIL | B-83) and the PowerShares DB Oil (DBO | B-88).

On the equity side, the giant in the space, the Energy Select Sector SPDR (XLE |A-96), is sure to get hit. XLE recently neared its 52-week low from earlier this year, but managed to hold above it. However, the ETF's biggest holdings, such as Exxon Mobile and Chevron, hit new lows for the year earlier in July.

Other popular energy ETFs that may see more downside action are the Market Vectors Oil Services ETF (OIH | A-48) and the SPDR S&P Oil & Gas Exploration & Production ETF (XOP | A-55).

USO, XLE, OIH, XOP 1-Year Performance

Source: Bloomberg
 

The Bottom Line
Iran’s nuclear deal spells trouble for crude oil, compounding the problems for a market that is already oversupplied. Energy ETFs will struggle in the short term, but a buying opportunity may emerge at lower prices.