Iran's reaction to US sanctions could cause an 'unintended' military conflict, says RBC's Helima Croft

Iran's reaction to the re-imposition of U.S. sanctions in November could lead to some kind of "unintended military escalation" – a risk currently underappreciated by markets, RBC Capital Markets closely-watched oil market expert Helima Croft said on Wednesday.

"We maintain that Iran 's response to the coercive measures will play an important role in determining the potential upward trajectory of prices," Croft and her team of oil analysts said in a note Wednesday.

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An Iranian military truck carries surface-to-air missiles past a portrait of Iran's Supreme Leader Ayatollah Ali Khamenei during a parade on the occasion of the country's annual army day on April 18, 2018, in Tehran.

The note titled "Winter is coming" warned that "if the Iranian regime restarts its nuclear program, increases support for regional proxy groups, or makes a genuine effort to restrict maritime traffic through vital chokepoints, fear price premium calculations will become of paramount importance."

RBC Capital Markets' base-case scenario is that Iran's Supreme Leader Ayatollah Khamenei will opt for an approach of "contained escalation" and will seek to avoid a direct military confrontation with its regional rivals, like Saudi Arabia and Israel, that support the U.S. sanctions.

Still, there's a risk that any retaliatory measures could get out of hand.

"An unintended military escalation through miscalculation continues to be one of the most underappreciated risks in our view," Croft and her team warned.

"Even if the probability of such a scenario remains relatively low, it would serve as the ultimate high-impact event for oil prices."

The type of Iranian "provocation" will matter materially for oil prices, RBC's team said, as will the reactions of powerful rivals such Saudi Arabia, Israel, and the U.S.

"If Tehran opts to avoid escalatory measures and attempts to wait out the Trump administration, the impact on oil prices would be more muted and largely limited to how many of its barrels are removed from the market by sanctions," Croft's team, including Christopher Louney, Michael Tran and Megan Schippmann, wrote.

While the analysts noted that trade war and emerging market contagion fears could still serve to keep a lid on prices in the near term, they believed "the geopolitical risks remain skewed quite heavily to the upside."

Emerging market currencies have succumbed to yet another sell-off – with some hitting record lows – as concerns rise about potential contagion across multiple regions.

Oil's 'fear premium'

Sanctions on Iran's oil industry are being re-imposed by the U.S. on November 4 after President Trump's decision to withdraw from an international nuclear deal. They will severely impact its oil industry, port operators, shipping sector and petroleum-related transactions. They follow a first series of U.S. sanctions, imposed in August, targeting other Iranian sectors.

The U.S. has warned other countries that they too will be hit by secondary sanctions if they buy Iran's oil.

The sanctions are expected to lead to export losses for the Islamic republic that surpass 1.2 million barrels a day (mb/d) during the first quarter of 2019.

"Beyond the barrel loss and the tightening fundamental backdrop, we think oil's fear premium could stage a comeback depending on the Iranian response," Croft and her team wrote.

Aside from Iran, geopolitical events affecting other oil producers, notably Venezuela, Nigeria, Iraq and Libya (along with Algeria, they are known as the "fragile five"), could also impact global oil supply and prices, accordingly.

"We started the year warning that the economic and political crisis in Venezuela could cause its production to plunge by close to 1 mb/d in 2018; we now anticipate that the snapback of U.S. sanctions could take similar volumes of Iranian exports off the market as the year comes to a close," Croft said.

"These two producers alone represent a very real supply gap risk of nearly two million barrels, and we continue to caution that an additional 500 kb/d is credibly at risk for periodic outages in Libya and Nigeria, as the security situation in both countries remains fragile and upcoming elections could bring additional unrest."

With oil supply disruptions a distinct possibility, market analysts are questioning the capacity of other major oil producers, like Saudi Arabia and Russia, to step up production if there are outages that prompt a sharp rise in prices.

Saudi Arabia is viewed as the "only holder" of significant spare capacity in RBC's view, but Croft noted that although it has ramped up output by more than 280, 000 barrels a day since May, "questions remain about how much more output it can easily bring on and about its willingness to risk another contraction in prices given its own domestic revenue requirements."

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