How will OPEC respond to a rise in Iran’s oil output?

Nader Habibi, professor of economics at Brandeis University, describes the tension between Iran's goal of increasing its share of the world oil market once sanctions are lifted and OPEC's desire to maintain a stable price for crude. He predicts that tensions between Saudi Arabia and Iran may drive OPEC to allow the price of oil to drop over the next few years.

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By Nader Habibi

The global market for crude oil will inevitably take notice of how the interim nuclear deal effects Iran’s oil exports. Over the past two years, under continuous pressure from international sanctions, Iran has been unable to find new customers for its oil, while existing buyers were forced to reduce their purchases by 10% to 20% every six months. As a result, Iran’s daily exports declined from 2.5 million barrels per day (b/d) in December 2011 to under one million b/d by November 2013. Accordingly, Iran had to cut back its total production from 3.5 million b/d in December 2011 to 2.7 million b/d in November 2013. 

OPEC headquarters in Vienna
OPEC headquarters in Vienna

During the past two years, however, additional output by OPEC producers like Iraq and Saudi Arabia has largely replaced the Iran's declining exports on the global market. Due to ongoing tensions between Iran and Saudi Arabia, the latter went as far as actively courting Iran’s oil clients like China, promising to sell them more oil if they reduced purchases from Iran. Non-OPEC producers such as the United States also enjoyed a boost in their oil output during this period, and as a result the oil market remained stable. Contrary to the Tehran’s predictions, declining Iranian exports did not cause a shortage of crude oil, and oil prices suffered only a moderate decline in this period. The spot price of Brent crude oil fell 3% in two years, from an average price of $111 per barrel in 2011 to $108 in 2013.

Iran’s declining output resulted in a sharp reduction in the government’s oil revenues and considerable economic hardship for its citizens. Te revenue shortage led to an exchange rate crisis in late 2012 and a sharp devaluation of Iran’s national currency. It therefore is no wonder that Iranian officials have been eagerly seeking reduced oil export restrictions in the context of the interim agreement. While the interim agreement does not allow Iran to expand its crude oil exports, it lifts the restrictions on exports of petrochemical products, which will generate some additional revenues in the range of $5 billion to $10 billion during the interim period.

Iran’s Oil Plans

Immediately after the interim agreement was signed in November, Iran’s newly appointed oil minister, Bijan Namdar Zangeneh, asked other OPEC members to honor Iran’s quota by scaling back their output as Iran restores its output to 2011 levels. The last official release of OPEC quotas allocated a quota of 3.3 million b/d to Iran, equivalent to 13.4% of the OPEC’s total production limit, not including Iraq.1 As of November 2013, Iran’s actual daily output averaged 2.7 million b/d, which was equivalent to 10.2% of total OPEC output in that month, excluding Iraq. If Iraq’s production is taken into account, Iran’s share of actual total OPEC production would constitute only 9.2%, which was significantly smaller than its quota. Consequently, if Iran increases its output to 3.3 million b/d, either other OPEC members will have to scale back their production or total OPEC output will rise, risking a further price decline. Furthermore, Zangeneh has warned that Iran plans to boost daily oil output to 4 million b/d as soon as the sanctions are lifted, which would require an even larger reduction in output from other members if OPEC wants to keep its total daily production stable.

OPEC oil production December 2011 vs. November 2013

While Iran has the technical capacity to boost output by up to 1 million b/d in the short run, the interim agreement—which went into effect on January 20—limits exports to current levels for the next six months. This means that even if Iran boosts its oil production, exports will not necessarily increase. Hence, it will not have any impact on the global oil supply. However, if Iran and the P5+1 can reach a final agreement during the next six months, it is very likely that such an agreement will raise the cap on Iran’s crude exports or remove the export sanctions altogether. In this case, other OPEC members will have to decide how to accommodate Iran’s larger export volume. Furthermore, while technical challenges will limit Iran’s daily output to under 4 million b/d in the short run, Iran is trying hard to attract international investment in its oil and gas sector. These investments could boost production capacity by up to 1 million b/d within two years. Denial of access to advanced upstream technology has been a leading cause of the gradual decline in Iran’s oil production capacity in the past few years. The Rouhani government is trying to reverse this trend with the assistance of international oil companies. The oil ministry is drafting a new incentive mechanism for investment by international oil firms to overcome the disincentives that drove many of them away during Ahmadinejad presidency. If these incentives are effective, Iran could increase its capacity to the 44.5 million b/d range by 2016.

OPEC’s Conundrum

Iran’s crude oil export volume is not expected to increase in the first half of 2014, but may grow by anywhere from 0.5 million b/d to 1 million b/d in the second half of the year. Furthermore, by 2016, Iran’s production and export capacity could potentially increase by another 1 million b/d. How will the global oil market, and OPEC in particular, respond to this increase in Iran’s export volume? It is unlikely that other OPEC members will easily accommodate Iran’s demand to restore its share of OPEC production to pre-sanction levels. Iraq has managed to expand its output in recent years despite domestic instability. Production is rising in both the autonomous Kurdish region and the Arab regions under the authority of Baghdad government. In light of the setbacks that it suffered during the last two decades and its large proven reserves, Iraq believes that it is entitled to a growing share of OPEC output as well. In addition to Iran and Iraq, which are both expected to increase their output in 2014, Libya is also trying to overcome labor strikes and political unrest that reduced its output in 2013 (although the situation in Libya remains uncertain).

Consequently, the only OPEC member that could realistically scale back its output in response to higher output by Iran and other members is Saudi Arabia. However, geopolitical tensions between Iran and Saudi Arabia have escalated since 2011. They have engaged in proxy wars against each other in Lebanon, Syria, and Iraq, and the Saudi government has not hesitated to express its displeasure toward the interim agreement between Iran and the P5+1. Any OPEC negotiations for realignment of the member quotas in 2014 are likely to be contentious, and it will be very difficult for members to reach an agreement. Hence it is likely that as Iran increases its export volume during 2014 or 2015, the aggregate OPEC output will increase as well. OPEC overproduction might even worsen if Saudi Arabia decides to harm Iran’s oil revenues by flooding the market and reducing the price of crude oil. Saudi Arabia’s 23 million b/d of excess capacity will allow it to take such an action. Indeed, during the Iran-Iraq War, the Saudi government drove the price of oil down to record low levels for a similar purpose.

Average price of crude oil

Increased output from OPEC in the next two years is likely to coincide with a continuous increase in oil production from non-OPEC countries. The United States is among the countries that will enjoy a significant growth in its oil production level. Long-term projections by the International Energy Agency (IEA) predict that the aggregate output of non-OPEC producers will grow by 6 million b/d from 2013 to 2018. The IEA does not expect the global demand for crude oil to grow by as much during this interval, and as such, the price of crude oil is likely to either remain stable or experience a decline in the next few years. Increased oil production by Iran after the removal of sanctions will help moderate the price of oil in two ways. First, it contributes to a larger aggregate supply of crude oil in the global market, and second, it increases the risk of disarray inside OPEC which can trigger a strategic output boost by Saudi Arabia which can lead to temporary price dives.

1. OPEC excluded Iraq from its quota system after the first Gulf War 1990-01 but has not terminated its membership. As Iraq’s production has increased in recent years other OPEC members have shown more willingness to bring it back into the organization’s quota system.

Nader Habibi is Henry J. Leir professor of the economics of the Middle East in the Crown Center at Brandeis University, where he is also senior lecturer in the Department of Economics.