As Iran Sells More Oil to China, the U.S. Gains Leverage

A new report from Bloomberg, citing data from Kpler, an analytics company, claims that Iranian oil exports to China will reach 1.5 million barrels per day this month, the highest level in a decade. The report has led to a flurry of criticism from hawks that President Biden is failing to enforce U.S. sanctions on Iran’s oil exports and thereby gifting Iran billions of dollars in oil revenue. But in reality, Iran appears unable to spend most of the money—a situation that is giving Biden leverage he can use in future negotations.

Iran’s resurgent oil exports are earning the country a lot of money. The crude oil price is currently hovering at around $80. Iran discounts its oil for Chinese customers, so the actual selling price is probably closer to $74 dollars per barrel. At this price, Iran’s 1.5 million barrels per day of exports are earning the country around $3.3 billion per month.

These back of the envelope calculations are necessary because China’s customs administration stopped reporting the value and volume of oil imported from Iran back in May 2019, when the Trump administration revoked a series of waivers permitting limited purchases of Iranian oil by select countries. When looking to the Chinese data alone, Iran’s export revenue appears much smaller than it is, hiding the true trade balance.

In the most recent three months for which we have customs data, Iran’s imports from China averaged $826 million. In the same period, Iran’s non-oil exports to China averaged $357 million. When not counting Iran’s oil exports, Iran appears to be running a trade deficit with China of around $469 million. But when adding the reasonable estimate of $3.3 billion of oil exports, the monthly trade balance swings dramatically in Iran’s favor. In recent months, Iran has likely run a trade surplus with China of around $2.8 billion per month.

In other words, Iran is earning billions of dollars it appears unable to spend. After all, Chinese goods, especially parts and machinery, are a lifeline for Iranian industry. If Iran was able to buy more Chinese goods, it would be doing so. Two other data points confirm this interpretation. Exports from the UAE to Iran remain depressed, so Chinese goods are not arriving in Iran indirectly. Purchasing managers’ index data for the manufacturing sector also indicates that Iranian firms continue to struggle with low inventories of raw materials and intermediate goods. Moreover, Iran is continuing to doggedly pursue the release of its frozen assets, including $6 billion that will be made available for humanitarian trade as part of the recent U.S.-Iran prisoner deal. Iran would not be so desperate to strike such deals were its oil revenues in China readily accessible. In short, Iran is selling its oil and earning money, but it is not getting the full economic benefit from the surge in oil exports.

Chinese exporters and their banks remain wary of trading with Iran, where entities and whole sectors remain subject to U.S. secondary sanctions. For most Chinese multinational companies, trading with Iran is not worth the risk. In the first six months of this year, Chinese exports to Iran averaged $898 million per month. Exports remain 35% lower than in the first six months of 2017, the most recent year during which Iran enjoyed sanctions relief.

It remains to be seen whether Iran can sustain this new, higher level of oil exports. Oil markets can be fickle, and China’s economic wobbles could depress demand. But for now, Iran’s significant trade surplus with China also means that its renminbi reserves must be growing. This is a novel situation. Historically Iran has run a small trade surplus with China. Between January 2012, when the Obama administration launched devastating financial and energy sanctions on Iran, and January 2016, when the implementation of the nuclear deal granted Iran significant sanctions relief, the average monthly trade surplus was just $511 million (China’s purchases of Iranian oil are reflected in customs data for this period). In other words, assuming its oil revenues are stuck in China, Iran’s reserves are now growing four times faster than in that period.

At first glance, this might look like a major failure for the Biden administration. Biden purposefully maintained the “maximum pressure” sanctions imposed by Trump in an effort to sustain leverage for negotiations and Iranian oil exports remain subject to U.S. secondary sanctions. But those who claim that Biden is failing to enforce his sanctions are failing to see the wisdom of the current U.S. enforcement posture.

First, Biden is loath to deepen already heightened tensions with China. Sanctioning Chinese refiners for their purchases of Iranian oil, thereby targeting China’s energy security, would be a dramatic escalation in the growing economic competition between Washington and Beijing. Second, such escalation would be entirely pointless given the circumstances around Iran’s oil exports—namely that Iran is not getting the normal economic benefits. Given that Iran is earning more money but cannot spend it, the U.S. is actually gaining leverage for future negotiations.

Unlike Trump, Biden has made a serious effort to engage in nuclear diplomacy with Iran and is likely to continue those efforts if there is a reasonable opportunity to achieve a new diplomatic agreement that contains Iran’s nuclear program. But U.S. negotiators have struggled to make a compelling offer to their Iranian counterparts. Many Iranian policymakers felt the promised economic uplift of sanctions relief would be too small. Iran’s opening gambit in the negotiations with Biden included the claim that sanctions had inflicted $1 trillion of damage to Iran’s economy and that Iran was owed compensation.

With its oil exports significantly depressed, Iran has been unable to significantly grow its foreign exchange reserves, which the IMF estimates at around $120 billion. If Iranian officials believe that they need to remediate $1 trillion of economic damage, the windfall represented by the unfreezing of foreign exchange reserves does not count for much.

The longer the sanctions remain in place, the more money will be needed to undo the cumulative effects of U.S. sanctions, which have now hobbled Iran’s economy for over a decade. It is politically impossible for Biden to promise any kind of compensation for Iran—the best that the U.S. can do is promise to once again unfreeze Iran’s own money as part of a new diplomatic agreement.

For this reason, it is a good thing if Iran’s reserves are growing. Iran’s oil exports to China are kind of like payments made as part of a deferred annuity insurance contract. One day, Iran will be able to cash out on that policy. But it can only cash out if it meets the conditions set by the U.S. In other words, every barrel of oil Iran is currently selling to China is increasing U.S. leverage for future talks. It would be wise to let the oil flow.

Photo: Canva

Iran’s Resistance Economy Is Kicking In

Farzaneh Sharafbafi, the first-ever female CEO of Iran Air, has just lost her job, a victim of U.S. sanctions on the Islamic Republic. Appointed in July 2017, Sharafbafi’s tenure was dogged by failures beyond her control. Of the 200 aircraft Iran ordered from Boeing, Airbus, and ATR, only 21 were delivered before the U.S. Treasury revoked the relevant licenses as part of the Trump administration’s “maximum pressure” campaign on Iran.

Sharafbafi’s replacement is Touraj Dehghani Zanganeh, a former air force commander and CEO of Meraj Air, a small airline which at one point operated the aircraft used by Iran’s president and foreign minister for diplomatic travel. Zanganeh was placed on the sanctions list by the U.S. last May.

The appointment of an individual sanctioned by the Trump administration is freighted with political symbolism: the Iranian government is signaling that sanctions designations will not influence decisions over the leadership of key industries.

More important, Zanganeh’s appointment exemplifies Iran’s renewed reliance on what its Supreme Leader, Ayatollah Ali Khamenei, has called a “resistance economy.” In order to overcome the restrictions imposed by sanctions, Iran will turn increasingly to a cadre of “resistance managers,” elevating individuals and empowering networks with unique capacities to keep Iran’s trade flowing under duress.

Given its long experience of economic sanctions, Iran has plenty of experienced “resistance managers” like Zanganeh. But their skills will be tested like never before as the U.S. ratchets up its sanctions regime—the latest round targets Iran’s metals sectors—and the economy sinks deeper into recession.

Government officials have vowed to adopt better monetary and fiscal policies in order to protect the public from the recession. But with trade with major partners like Europe and China collapsing, Iran needs to continue buying and selling goods, and earning hard currency, in sufficient quantities to keep the economy turning, even at a slower speed.

In the case of Iran Air, sanctions don’t just end the acquisition of new aircraft, but also significantly restrict the ability to secure spare parts for its existing fleet, to receive ground handling services at airports, and to sell tickets to passengers around the world. Iran Air no longer needs a CEO who represents the renewal of Iran’s aviation industry.

The government is betting that Zanganeh is a manager who can procure—by any means necessary—what the airline requires to keep its planes aloft. It is telling that he was designated by the U.S. Treasury as part of a procurement network. With his military background, Zanganeh also has the authority necessary to cut Iran’s national carrier to size as its commercial prospects darken. The airline has a workforce of over 11,000 and a fleet of just 53 aircraft. Competitor Mahan Air, which has 64 aircraft, has a third of the employees.

Not all companies will change their CEOs, but across Iran’s industrial sectors, many will increasingly outsource their procurement needs to intermediaries and front companies that use both legitimate and illegitimate channels. Such measures can already be seen in the embattled oil sector, reeling from the Trump administration’s recent decision to revoke waivers that allowed Iran to export its crude oil to major customers such as China and India. Speaking on the sidelines of a major oil and gas conference in Tehran, where the presence of foreign exhibitors had fallen from around 600 companies in 2017 to just 60 companies this year, deputy oil minister Hossein Zamaninia told journalists Iran could sustain exports, adding: “We have mobilized all of the country’s resources and are selling oil in the ‘gray market.’”

Analysts expect Iran can sustain exports of around 500,000 thousand barrels per day by leveraging gray-market channels. Zamaninia argued this would not constitute “smuggling,” because Iran doesn’t regard the sanctions “as just or legitimate.” Zamaninia has a point, considering that the U.S. is the only country seeking to enforce a global embargo on Iran’s oil exports.

But definitions aside, it was long expected that Iran would respond to attempts to limit its oil exports by resorting to smuggling, with the Islamic Revolutionary Guard Corps (IRGC) and other quasi-state intermediaries resuming the lucrative roles they had played in the previous sanctions period. Every day, hundreds of motorbikes strapped with jerrycans cross the border between Iran and Pakistan, taking Iran’s cheap gasoline to markets where it can be sold for a hefty profit. Some estimates suggest that 22 million liters of gasoline are smuggled out of Iran daily.

By choking off key exports and limiting access to banking channels, U.S. sanctions seek to limit Iran’s ability to earn and repatriate enough foreign currency to keep its market supplied. But the cash economies of Iraq and Afghanistan, flush with dollars due to the U.S.-led invasions, offer an important lifeline. Reports suggest as much as USD 2-3 million dollars in hard currency are daily being transported from Afghanistan to Iran. A similar trade exists with Iraq.

Central to these methods of “resistance management” is a selectively porous border. Iran needs to allow goods and money to cross into the country away from the scrutiny of the usual trade routes. But at the same time, the state cannot allow uncontrolled export smuggling, instances of which have already exacerbated shortages of basic foods and consumer goods at home. In March, officials from Iran’s agricultural ministry announced that due to a failure to “monitor and control the movement of livestock,” which saw whole herds smuggled to neighboring countries, and which drove the price of meat to historic highs, the responsibility for counter-smuggling activity had been handed over to the IRGC.

Iran needs to keep the economy turning with the bandaid solutions of resistance management, even if it means undoing the hard-fought reforms that had helped make Iran’s economy a little more globalized, more transparent, and less state-controlled over the past few years. As one senior Iranian official told me at a recent meeting: “If we are going to be treated like bandits, we might as well behave like bandits.”

Photo: ISNA

Iran Budget Under Scrutiny As Oil Revenues Fall

Next week, President Hassan Rouhani will submit a budget proposal for the forthcoming Persian year (covering March 2019-2020). The budget bill’s adherence to fiscal rules and the reasonableness of its estimates will be under intense scrutiny given the volatile political and economic climate in Iran.

Policymakers and business leaders see the budget as having four purposes: to maintain economic stability, to boost economic growth, to expand redistribution for poverty reduction, and to supply public goods. Given limited resources related to the reimpositon of sanctions, the Rouhani administration intends to focus on the latter two goals. For example, the administration is slated to earmark USD 14 billion of its hard-earned oil dollars to ease importation of a group of 25 items classified as basic goods and medications.

In the face of such emergency expenditures, the cabinet must carefully balance its budget to ensure that spending is kept in line with revenue, especially given the impact of sanctions on the contribution of oil revenues. 

Assuming that Iran will continue to sell 1 million barrels per day (mbpd) of crude oil at USD 54 per barrel, total oil revenues next year will reach approximately USD 20 billion or about IRR 1,140 trillion, at the effective official exchange rate of IRR 57,000. More optimistically, if Iran can manage to keep exports around 1.5 mbpd, the state will earn USD 30 billion, or IRR 1,710 trillion.

According to Iran’s Sixth Development Plan, which establishes guidelines for government budgets and covers a five-year period from 2016, revenue estimates for oil and gas condensate exports cannot exceed a forecasted IRR 1,150 trillion by more than 15 percent. As such, the budget must technically be balanced based on oil revenues of IRR 1,300 trillion. A draft version of the budget places oil revenues at IRR 1,690 trillion, flouting the rule.

Moreover, the Sixth Development Plan mandates that 14.5 percent of oil revenues be allocated to the National Iranian Oil Company, 34 percent to the National Development Fund of Iran (NDFI) and 3 percent for investment in Iran’s underdeveloped regions. The remaining revenues are earmarked for use by the central government.

In an effort to increase its available resources, the Rouhani administration planned to cancel the allocation of oil revenues to NDFI. But Iran’s Supreme Leader, Ayatollah Ali Khamenei, intervened to ensure NDFI secures at least a 14 percent allocation. When allocations are reduced, the government typically does not actually transfer the diverted revenue to the Central Bank of Iran, maintaining the funds outside of Iran. This means that the government is effectively printing money, adding inflationary pressure.

A further challenge for the Rouhani government will be that even if oil revenues can be sustained, sanctions will force the government to receive most of its foreign exchange earnings in currencies such as the Indian Rupee, Iraqi Dinar, Turkish Lira and Chinese Yuan. These funds, deposited into escrow accounts as governed by the Significant Reduction Exemptions (SREs) issued by the Trump administration to eight of Iran’s oil purchasers, will not prove as valuable or liquid.  

While some have speculated that allowing the rial to depreciate could have served to minimize a budget deficit given the large proportion of foreign exchange revenues, the overall reduction in oil revenue and the need for new expenditures, such as allocations for the import of basic goods and pharmaceuticals, negates any benefit.

In the same vein, given high interest rates on Iran's debt market during the sanctions era, the government will face difficulties in repaying its deferred debts through the issuance of bonds. Furthermore, the Plan and Budget Organization of Iran is set to issue new debt in 2019-20 close to the IRR 560 trillion ceiling specified in the Sixth Development Program.

With revenue squeezed for the reasons outlined above, Rouhani will be under pressure to reduce spending, especially through the elimination of subsidies. First, the administration could decide to end the allocation of subsidized dollars for the import of essential goods and medication. This may exacerbate inflation, but it is not clear as to whether the subsidies are actually serving to keep consumer prices low, or whether importers and wholesalers are padding their profits. If inflation continues slow in coming months as the rial regains value, there may be a case for reducing the subsidy.

Second, the some economic commentators have proposed eliminating subsidies for fuel in the favor of shopping cards that enable households to get discounted prices for essential foodstuffs. This would replace a subsidy for essential goods importers with a subsidy for consumers. Not only would such an approach protect foreign exchange reserves, it arguably would more effectively support underprivileged groups in the society.

Currently, the Rouhani administration has few options as it seeks to avoid a budget deficit. Yet the political tradeoffs required when devising a budget under sanctions may prove more difficult to manage than the economic challenges.

Photo Credit: IRNA

Can Iran Weather the Oil-Sanctions Storm?

This article has been republished with permission from the European Council on Foreign Relations. 

In the coming weeks, the US administration will intensify its economic pressure on Iran through sanctions designed to curtail the country’s oil exports. Given that these exports account for a significant percentage of state revenue (despite government efforts at economic diversification), the measures will hit Iran hard. Yet the sanctions will also have an impact on energy markets far beyond Iran, and may lead to a rise in global oil prices. Moreover, they could have a negative effect on global energy security by tapping into most of the spare capacity in the market.

Since President Donald Trump withdrew the United States from the Iran nuclear deal (formally known as the Joint Comprehensive Plan of Action, or JCPOA) in May this year, US officials have stated that they aim to prevent Iran from exporting any oil whatsoever. Although the second phase of the new US sanctions only come into effect on 4 November, Iranian oil production and exports have already started to decline – partly because the US has issued conflicting statements on whether it will provide sanctions waivers to some importers, and partly because the August 2018 round of US sanctions set restrictions on payments, shipping, and insurance.

If the Trump administration truly seeks to ensure that Iran will export no oil, this is a strikingly different approach to that both the Obama administration and the European Union pursued between 2012 and 2015. These earlier measures caused Iran’s oil exports to drop by around 40 percent, to an average of 1.5 million barrels per day (mb/d). In contrast, the new sanctions are likely to reduce Iran’s oil exports to less than 1 mb/d by November. There are several reasons for this difference. One is that the Trump administration has taken a much tougher stance on importers of Iranian oil. Under the Obama administration, the US expected other countries to significantly reduce but not totally end their imports of Iranian oil. Although the Obama administration never stated a clear target for this reduction, it amounted to around 20 percent. Notably, the EU also banned imports of Iranian oil and EU member states halted almost all such imports.

Having borne the brunt of US secondary sanctions in 2012-2015, companies and countries around the world are now well aware of the consequences of non-compliance. They also have a good idea of how accurately the US tracks Iranian exports and how far its surveillance capabilities reach. The Obama administration had to engage in extensive negotiations with importers of Iranian oil to explain the consequences of non-compliance. This time around, the rules of the game are much clearer.

Another factor is that, unlike in 2012, there now is enough oil to make up the shortfall in the market. In recent weeks, traders and importers of Iran’s oil have said they can easily find substitutes for the product. Major oil producers such Saudi Arabia, the United Arab Emirates, and other OPEC members have collectively increased their supply of oil by around 1 mb/d since May, and have signed contracts with importers to provide substitutes for Iran’s oil in the future. However, this substitution of Iranian oil weakens the security of global energy markets: buyers are tapping into most of the world’s spare oil production capacity, heightening the risk of a rise in oil prices.

As oil prices are now much lower than they were between 2012 and 2015, the discount rates at which Iran hopes to export oil provide relatively little incentive for buyers to violate US sanctions. Meanwhile, by restricting financial transactions with Iran and the insurance of Iranian oil, the US sanctions that came in to force in August 2018 have created a tighter regime than that implemented under the Obama administration.

New Obstacles to Iran’s Exports

Ambiguities over how the US will enforce its sanctions make it difficult to estimate the size and duration of the coming decline in Iran’s oil exports. While the US sanctions in place during 2012-2015 accompanied similar EU measures and had a basis in UN sanctions targeting Iran’s nuclear programme, the US is now implementing unilateral sanctions while Russia, China, and Europe continue to support the sanctions relief specified in the JCPOA.

Yet US secondary sanctions have proved to be powerful. There are indications that importers of Iranian oil such as Japan, South Korea, Sri Lanka, and most European countries will no longer buy the product after November. Although China has consistently stated that it will continue to import oil from Iran, it is also attempting to use this position as leverage against President Trump in its ongoing trade war with the US. India, which buys more Iranian oil than any country other than China, significantly reduced its imports of the product in August, but is still negotiating with US administration over sanctions waivers.

Following the introduction of US sanctions on Iran-related financial transactions and oil tanker and cargo insurance, Iran’s crude oil exports dropped from an estimated 2.3 mb/d in July 2018 to less than 2 mb/d the following month. As such, the cause of the decline is not necessarily compliance with the US ban on Iran’s oil imports but rather the new challenges of paying for, and safely transporting, the product. Judging by purchase contracts at the National Iranian Oil Company and other sources, exports of Iranian oil may drop as low as 750,000-850,000 b/d by November.

In August, amid this sharp decline in Iranian oil exports, OPEC increased oil production to 32.89 mb/d, its highest level in ten months. It appears likely that OPEC will further increase production, despite Iran’s efforts to lobby against such a move. Potentially adding to Tehran’s woes, Russia – which is not a member of OPEC – increased its oil output by around 148,000 b/d to 11.215 mb/d in July, coming close to its post-Soviet record high of 11.247 mb/d. 

As no sanctions regime is immune to shifts in the market, time could work against the US policymakers targeting Iran. Along with the increased oil supply from OPEC countries and Russia, other market conditions could have a drastic effect on Iran’s oil exports. The US administration’s ambiguous statements on the scope and duration of its sanctions could lead to non-compliance and even cause the measures to fall apart earlier than planned. For instance, if countries such as India and China continue to import discounted Iranian oil while others stop doing so, the sanctions regime may gradually become ineffective. This is especially so given that, if oil prices rise in line with market expectations, Iran’s discounts on barrels of oil and freight costs will become increasingly appealing.

Nonetheless, the new round of US sanctions will undoubtedly damage Iran’s economy. At a time when it is grappling with several domestic economic challenges, the Iranian government will have to be careful in dealing with further cuts to its revenue. Of course, having survived a series of US and EU oil embargos in the last four decades, Iranian leaders may decide to weather this latest storm through strategic patience and reliance on an “economy of resistance”. Tehran may feel it can manage these sanctions while continuing to comply with the JCPOA, allowing the measures to gradually erode.

China, Russia, and many European countries seemingly aim to support this approach, creating financial incentives that maintain Iranian compliance with the JCPOA (even if most European countries and companies are likely to comply with US sanctions). These incentives will be designed to help Iran’s economy survive the sanctions, partly by mitigating the decline in Iranian oil exports.

It is unclear whether this approach will work. The Iranian economy currently appears vulnerable to the new sanctions: the Central Back of Iran has been forced to devalue the rial much faster in recent months than it did during 2012-2015. The aftershocks of the currency devaluation and rapid inflation may exacerbate the sporadic unrest across the country that began last January – mostly due to Iranians’ economic grievances.

If American sanctions truly block the majority of Iran’s oil exports, the country may opt for an aggressive response. Iranian leaders, including President Hassan Rouhani, have suggested that Iran will disrupt oil shipments from neighbouring countries, targeting the Strait of Hormuz and/or Bab el-Mandeb. Iran could also engage in cyber sabotage or attacks in the Middle East intended to create panic among oil traders, driving up global oil prices. Such operations would create widespread chaos and perhaps lead to the formation a global political and military alliance against Iran.

The prospect of further talks between Tehran and Washington is fading as Iran’s oil production and exports continue their decline. But the ongoing negotiations between Iranian leaders and supporters of the JCPOA may produce a compromise that encourages Iran to wait patiently, in the hope that the course of events will turn in its favor and it will overcome the sanctions.

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