Iran and the world’s major geopolitical powers are working out a deal over the country’s nuclear aspirations. If they reach a deal by June 30, international sanctions against Iran could be lifted by the year’s end. Such a monumental achievement in world diplomacy after 35 year of strife would have major implications for oil prices and the stock market.
The European Union and U.S. lifting sanctions against Iran – home to the planet’s fourth-largest known crude reserves – could reduce oil prices by opening the doors for an underutilized resource of crude oil. The country of 80 million people is also home to the world’s second-largest known natural gas reserves. Iran houses nearly 13% of OPEC crude reserves and 10% of the world’s total crude oil reserves, the U.S. Energy Information Administration calculates. Iran is estimated to have at least 30 million barrels stockpiled.
Iran is expected to increase output capacity by 700,000 barrels per day by the end of next year. It will be a long time before the country’s distribution and output accelerate so oil prices won’t crash in one day. Unless the expected flood of new supply is offset by cuts in other places, the foreseen new oil supply should dampen any rallies in crude prices.
Inexpensive oil would be good and bad for U.S. gross domestic product. Given that consumers account for 70% of GDP, low pump prices would leave them with more cash to spend on other things. On average, gas accounts for 5% of all household spending. The EIA estimates, on average, American households will spend about $550 less for gas in 2015 than in 2014. Annual consumer spending on gas is on course to fall to its lowest level in 11 years as a result of low gas prices and higher fuel efficiency in automobiles.
However, low oil prices slash profits and sales for the energy sector. As a result, oil & gas companies have to fire workers and cut capital investments. This particularly painful for oil-rich states like Texas and North Dakota.
FactSet forecasts the energy sector’s Q1 earnings to crash 65% year-over-year, posting the largest decline among the 10 S&P sectors. If the energy sector is taken out, the estimated earnings growth rate for the S&P 500 will jump by 3.3% from a minus 4.8%, FactSet stated in an April 10 report.
Sales for the energy sector in Q1 are estimated to nosedive 39% year-over-year. Excluding energy, total S&P sales would rise 3% instead of fall 3% for Q1. In total, the good should outdo the bad, considering that the energy sector accounts for 5.9% of U.S. GDP, while consumer spending makes up 70%.
Budget Deficit and Interest Rates
An end to the conflict with the public enemy numero uno eliminates a major geopolitical risk for the stock market that would be like the Soviet Union’s fall. The U.S. would have one less industrialized military threat. That would allow the U.S. to reduce spending on the military. Government spending on the military totaled $610 billion, or 3.5% of U.S. GDP, in 2014, according to the Stockholm International Peace Research Institute.
Against this backdrop, U.S. tax revenue is expected to rise to new highs this year. A combination of less military spending and more fire power in the government’s wallet could lead to less issuance of Treasury debt and a lower budget deficit. Less debt issuance could support the greenback, while lower interest rates could stimulate economic growth.
Research conducted by leading economists has found a correlation between interest rates and budget deficits, although how much fiscal deficits affect interest rates is debatable. When the projected deficit-to-GDP ratio rises by one percentage point, long-term interest rates increase by about 25 basis points. That’s according to research by Thomas Laubach, an economist and director on the Board of Governors of the Federal Reserve System.
Economists R. Glenn Hubbard and Eric Engen’s research, on the other hand, found that when Uncle Sam’s debt increases by 1% of GDP, interest rates climb by about two basis points. The research suggests that a balanced budget may cut interest rates between 10 basis points and one percentage point.
The U.S. still considers Iran an active terrorism sponsor. The upshot of the negotiations is up in the air. What kind of deal will be achieved is a mystery. Members of the Congress could oppose lifting U.S. sanctions even if a deal is made. However, U.S. corporations could pressure Congressional members to lift the sanctions if they see their counterparts in Europe making money from doing business with Iran. Should the deal with Iran collapse, the stock markets are likely to lose any gains from a rally that ignites after the initial signing.