What to expect from Iran?

How low can oil go? For Canadians, the plunging price of oil means direct economic pain in the west, along with rising prices for food and other imports as our dollar drops with it. Those looking for clues about whether 2016 will bring a price recovery have largely focused on how the U.S.-Saudi oil-price war will play out. But attention needs to be paid to the rapidly changing situation inside Iran.
We hear about Iran mainly in connection with external factors: the nuclear deal struck last year, regional hostilities, its emerging alliance with Russia. But a closer look at Iran’s internal economic picture sheds light on the role it will play in keeping the price of oil depressed in coming years.
Iran was subject to intense sanctions for its nuclear program during 2010-2013. The sanctions hurt Iran’s economy badly and limited its ability to export crude oil. It became isolated from the international financial system and international trade, and many of its properties and assets were frozen. To deal with mounting deficits, the Iranian government slashed infrastructure budgets and administrative costs, adding to already double-digit unemployment figures.
Inflation had already been accelerating due in part to a botched subsidy-reform plan by former president Mahmoud Ahmadinejad. He cut subsidies on food and energy and planned to redistribute half of the saved money to poor people. However, due to a lack of data and other implementation problems, the government ended up simply giving cash to all households, as it could not identify who qualified for compensation. Depreciation of its currency, the rial, due to the decreased oil exports, exacerbated this problem, pushing inflation to 40 per cent.

In 2013, President Hassan Rouhani was elected on a promise of better relationships with other countries. The dramatic crash of oil prices in 2014 amplified the pressure on him to fix the economy. Mr. Rouhani made his first priority to cut inflation. In particular, his government controlled the fluctuations in the exchange rate to prevent depreciation against the U.S. dollar, and implemented extensive, contractionary policies to decrease the monetary base.

Inflation fell to 16 per cent, which was an impressive achievement considering where it had been not long before. But the policies intensified the existing recession. Iran is now suffering from weak domestic demand, in part because consumers are deferring spending based on the expectation that prices will drop due to monetary reforms and the recent lifting of sanctions.

Thus, the next challenge facing the Iranian government is to boost domestic demand, which the nuclear pact and the removal of sanctions should help bring about. The lack of sanctions will allow Iran to get its oil back to market, and the government intends to dramatically increase its capacity to export crude. Although this may further depress the world oil price, the net effect will be positive for Iran’s economy. In addition, the absence of sanctions will allow Iran to attract increased foreign direct investment, upgrade its oil fields and take aim at decreasing the unemployment rate.

So for 2016, all signs point to Iran rapidly attempting to get oil production up to full capacity as it puts the era of sanctions and isolation behind it. Even if Saudi Arabia begins to relent in its price war with the United States, and even if high-cost producers in North America reduce capacity, Iran is waiting to fill the gap.

Investors looking for clues about how the price of oil will move this year need to look past the external strategic issues that dominate news from Iran, and look at its internal economic priorities. These suggest that Iran will be a source of downward pressure on the world oil price over the next few years, which will likely make an already bad situation worse for the oil markets.