John Kemp : Iran oil sanctions
are an unpredictable gamble
If war is merely the continuation of policy by other means, aimed at compelling our enemy to do our will, as military strategist Carl von Clausewitz maintained, then sanctions are a form of warfare without overt fighting.
For the last few years, Iran has been locked in an intensifying, undeclared war with Israel, the United States and their allies in Europe and the Middle East.
Sanctions on Iran's oil exports are simply the most recent and visible element of a complex conflict that also includes covert operations, sabotage, the arrest of agents and the abduction of scientists, engineers, agents and policymakers on both sides.
Sanctions are often portrayed as a diplomatic alternative to war, but a more realistic assessment sees them as simply as one tool in an intensifying political, military and economic confrontation.
For both Iran and its enemies, the conflict is existential. Israel fears a nuclear-armed Iran would fatally undermine its ability to guarantee the safety and security of its own citizens. Iran fears encirclement by hostile powers attempting to overthrow the government and affect regime change.
The conflict's total nature makes it difficult for either side to back down. It also makes the escalation sequence extremely unpredictable since neither side may be willing to compromise short of achieving its maximum aims.
The confrontation seems more likely to end with Iran acquiring nuclear capability and/or the government in Tehran being overthrown than a diplomatic compromise and a return to negotiations or the suspension of the enrichment programme.
For the oil market, the important question is not whether sanctions will be imposed (the initiative appears to have acquired unstoppable momentum in the strategic studies community) but how the conflict will develop once the EU and other states announce their restrictions on imports from Iran.
Global oil production and consumption stood at around 89 million barrels per day (b/d) in November, according to the International Energy Agency's latest "Oil Market Report".
Iran produces just over 3.5 million barrels of crude a day, and exports around 2.5 million.
The only country with significant unused production capacity is Saudi Arabia , which produced 9.75 million b/d in November, according to the IEA, and slightly more according to Saudi sources, but has capacity to pump as much as 12 million b/d.
Iran's output is therefore roughly equivalent to total spare capacity in the global market. The market cannot afford to lose all or a significant part of that output as it would cut spare capacity to zero and make the market exceptionally vulnerable to any unexpected growth in demand or output losses elsewhere.
If sanctions cut Iran's exports, losses would have to made up by higher Saudi production or from emergency stocks held by IEA member countries and other importing countries such as China .
Any increase in Saudi output will cut the market's margin of spare capacity. Release of emergency inventories cannot be sustained indefinitely (IEA government-controlled stocks were just 1,500 million barrels at the end of November).
So assuming the oil market is currently "balanced" at present levels of supply, demand, capacity and inventories with prices at $112 per barrel, any bid to cut Iran's exports would force prices substantially higher to reduce consumption until the margin of spare capacity and inventories has been restored.
If sanctions cut Iran's exports significantly, the most likely consequence will therefore be higher prices and a slowdown in both global growth and oil consumption.
To avoid this costly outcome, early sanctions proposals suggested the EU would embargo imports from Iran and force the country to boost its exports to Asian markets at a discount. The total volume of exports would not change, ensuring world prices did not rise, but the composition of Iran's markets and its earnings would be adversely affected.
But sanctions legislation approved by the U.S. Congress seeks to cut off, or reduce, Iran's access to markets in Asia as well. The combination of the restrictions contained in the National Defense Authorization Act (PL 112-81) and the proposed EU import ban implies Iran's exports could fall significantly in the coming months by anywhere from 200,000-300,000 b/d to as much as 1 million b/d or more.
Saudi Arabia could certainly offset these losses by increasing its own exports, and the IEA would almost certainly cut several hundred million barrels from government inventories.
Whether it would succeed in averting a rise in prices depends on whether the market perceives the loss of exports as temporary or permanent, and whether any confrontation worsens and leads to the loss of even more, perhaps cutting exports to zero, or results in a swift compromise.
It is far from clear Iran would back down quickly. Sensing an existential threat, the government in Tehran might remain defiant or choose to escalate. If so, exports could be lost for an extended period, gradually running down emergency stocks and eroding Saudi spare capacity.
One unintended consequence is that Iran will take over Saudi Arabia's traditional role as the swing producer, holding much of the idle capacity needed to meet an unexpected surge in demand or outages elsewhere.
The global oil market could probably just about absorb the loss of up to 1 million b/d of Iranian exports on an ongoing basis, albeit at higher prices. But it is not clear what would happen if more output was lost because of the deteriorating political situation in Iraq and protests in Nigeria, production losses in the North Sea or a natural disaster such as hurricane in the Gulf of Mexico .
Would the EU and the United States relax sanctions (temporarily or permanently) to offset the intense upward pressure on oil prices?
The impact on Iran's revenues remains unclear. Most strategic studies analysts assume sanctions would cut volumes and/or force the country to discount its crude, reducing its export earnings. But Iran might see little or no impact, even gain, if sanctions push traded oil prices higher.
For a small reduction in volumes (200-300,000 b/d) and small discounts ($5 per barrel), the impact on Iran's earnings might be offset by a $10-20 per barrel increase in international oil prices. For a really big cut in volumes (1 million b/d or more) and hefty discounts ($20 plus), the impact on earnings would probably be negative, but oil prices might surge $50 or more, risking serious harm to the world economy.
None of the leading sanctions advocates has published meaningful estimates of how much volume would be lost, how much Iran might be forced to discount its oil, or how far traded prices might rise in response to the combination of an EU embargo and lower crude purchases by Asian customers such as Japan and South Korea.
For all the detailed planning behind the scenes, sanctions policy, like battle plans, is unlikely to survive first contact with the enemy.
Once sanctions are imposed the results in terms of oil supply and prices are likely to be quite unpredictable. No one knows for certain how Iran would respond, how much export volume would be lost, or for how long, and how the market would evolve in the light of other shocks to supply and demand.
To improve their political acceptability, advocates have portrayed sanctions as a carefully calibrated and low-cost way to ratchet up pressure on Iran and force the country's government to suspend its enrichment programme without sparking an uncontrolled escalation of violence.
In reality, sanctions are a gamble: a bet Iran will not choose to escalate further; a bet the oil market can absorb the loss of exports without serious difficulty; and a bet nothing else will go wrong in other producing countries.
Once sanctions go into effect, no one is quite sure how Iran and oil prices will respond.
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John Kemp is a Reuters market analyst. The views expressed are his own . Petroleumworld does not necessarily share these views.
This commentary was originally published by Reuters on
January 10, 2012
. Petroleumworld reprint this article in the interest of our readers.
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Petroleumworld News 01/11/2011
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