INTELBRIEF

September 24, 2012

TSG IntelBrief: Inching Closer to Compromise on Iran's Nuclear Program

As of late September 2012, the pressure brought by international sanctions is becoming unsustainable for Iran's economy. The value of the rial, Iran's national currency and a key indicator of the country's economic health, has been cut in half from what it was a year ago, losing approximately 20% of its value in the month of August alone. Experts attribute this dramatic fall to the accelerating pace at which Iranians are moving their money out of the country, a process that requires the conversion of rials to dollars. This frenzied response by so many Iranians has had the unintended consequence of driving the value of the dollar up against the rial.

Some Iranians who cannot move their money outside Iran are instead trying to acquire hard assets — primarily real estate. While real estate values have been increasing and the rial's value plummeting, inflation has soared. However, only a small number of Iranians are able to buy property, meaning the combination of rising inflation and a declining currency is severely harming Iranians in the middle and lower classes.  

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Causes of Economic Panic

The cause of the sudden and severe economic downturn is not difficult to pinpoint. The European Union's embargo on purchases of Iranian oil took full effect on July 1st. That move alone deprived Iran of about one-quarter of its average oil export volume of 2.5 million barrels per day. At the same time, U.S. sanctions penalizing countries that do not cut oil purchases from Iran went into effect as well. The combined impact of these sanctions has, as of September, cut Iran's oil exports to about 1.2 million barrels per day — about half of what they were in 2011. Given that Iran earned approximately US $100 billion from oil sales in 2011, it can now expect to lose about $50 billion from those sales in its current budget year.

Average Iranians and currency traders know that additional damage is looming and the value of the currency is likely to fall even further. U.S. sanctions — including a new sanctions law signed in August 2012, The Iran Threat Reduction and Syria Human Rights Act of 2012 — allow countries to avoid penalties if they keep cutting purchases from Iran every six months. Twenty countries obtained such sanctions exemptions during the period of March to June 2012, and these are up for renewal from September until the end of the year. With the expected additional cuts in purchases, Iran's oil exports will almost certainly fall below one million barrels per day by the end of 2012.

A loss of income this dramatic — and oil accounts for about 70% of government revenues — is unsustainable for Iran. Within a population of 75 million, at least 60 million Iranians receive some form of government assistance. That aid is commonly delivered as direct payments or other forms of social welfare. A loss of more than half of Iran's oil income means the government will not be able to fulfill its social welfare obligations without drawing down its foreign currency reserves, which were estimated at around US $100 billion before the oil sanctions took effect this summer. These factors explain why many Iranians have said in interviews that Iran's economy is likely to collapse completely by the end of 2012.

Moreover, many Iranians realize the sanctions are eroding future earnings potential. For example, sanctions have caused most major international energy companies to pull out or wind down their business in Iran. Less technologically advanced Iranian firms — or those from developing countries such as Vietnam and Belarus — have moved in to fill this void, but these companies are not able to keep Iran's fields as productive as when they were managed by the international majors, to include ENI of Italy or Total of France. Nor are new fields being developed as international investment has almost completely dried up.  

Perhaps even more harmful is the fact that Iran has had to cut oil production to accommodate the loss of oil customers. Before the imposition of oil sanctions, Iran was producing nearly 4 million barrels per day. When sanctions went into effect in July, Iran at first tried to store unsold oil on tankers afloat in the Persian Gulf or in storage tanks onshore. Having exhausted the available storage capacity, Iran has cut production to about 2.6 million barrels per day, meaning that it is now producing less oil than Iraq. And fields that are taken out of production become damaged and difficult to revive for production later if needed. The consequences for Iran are increasingly grievous: just six months ago, the country was a major oil producer and exporter; today, it finds itself facing near total marginalization in the world oil market.

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Leadership Reaction

Tehran is not unaware of the difficulties sanctions are imposing on the country's most valuable assets. Iranian leaders, particularly President Mahmoud Ahmadinejad, have publicly discussed how much economic damage sanctions are causing, even while asserting that Iran can mitigate the effects with its large foreign currency reserves and other measures.

What the leadership has not done to date is signal clearly and unambiguously that it is willing to compromise with the international community on its nuclear program. In three rounds of high level talks held in April through June 2012, Iran at times indicated a willingness to discuss limitations on its enrichment of uranium, but it did not accept the international community's proposals. The idea of talks is not dead, and lower level discussions are continuing, but little chance of a breakthrough appears imminent.  

The international community appears to be betting that sanctions will bite so deeply that Iran will be forced to compromise in the relatively near future. Iran's economy is in such a trajectory that the international bet might be well founded. However, Iranians have faced severe deprivation before — particularly during the Iran-Iraq war of 1980-88 — and it cannot be assumed that Iran's leaders will capitulate due solely to economic hardship. If a struggling economy leads to significant street unrest, then it is likely Iranian leaders might come to a different conclusion and seek an early deal on the nuclear issue.

That Tehran has indicated a potential willingness to limit its uranium enrichment suggests its leadership is mindful of the fact that a beleaguered economy could set the stage for serious unrest, and that they are looking for a compromise. But Iran's leaders might be calculating they can continue to hold out until they are assured that, in exchange for limiting nuclear enrichment, all oil and related sanctions will be eased. Such a broad easing was not offered by the international negotiators in the three rounds of talks in 2012. Nonetheless, for the Iranian leadership, it is virtually impossible to reach an agreement with the international community unless those sanctions are rolled back in return. Even if popular unrest returns to Iran's streets, the leadership will blame U.S. and international intransigence for the economic hardship if substantial sanctions relief is not offered.

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Threat of War in the Background

Some in the international community, particularly the leadership in Israel, have begun to sour on the prospects for sanctions and to shift the discussion to possible military options. Tehran seeks to avoid provoking a military strike, but it also appears to have calculated that Israel is unable to militarily eliminate its nuclear program. Further, Tehran seems to believe that Israeli military action would cause many countries to cease complying with international sanctions. Iran does fear a U.S. strike, but is apparently convinced that the United States will not take that step because of war-weariness among the U.S. public and the fear of the unsettling consequences for oil prices. Therefore, a military threat alone is not likely to motivate Iran's leaders to compromise to the degree that an offer of comprehensive sanctions relief would. In this geopolitical standoff, the economic carrot seems to have far more potential to influence a change in Tehran's position than the possible military stick. Also available: The Soufan Group's world-class network of intelligence analysts produces specialized geopolitical and risk assessment products tailored to the unique needs of our clients in the public and private sectors. We welcome the opportunity to discuss your requirements and explore how our intelligence services can assist you in achieving your strategic objectives. For more information, please contact us at: info@soufangroup.com

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