Will the Iran Sanctions Spark an International Oil Crisis?

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Western governments are trying to stop Iran's nuclear program by cutting off its oil revenue. Will they tank the world economy in the process?

615_Iran_Oil_Flag.jpgReuters

As if the global economy wasn't chaotic enough these days, the escalating conflict over Iran's nuclear ambitions is now threatening to wreak havoc on the world oil market. On December 31, President Obama signed into law the toughest American sanctions yet against Tehran, which aim to cut off the country's petroleum revenue by penalizing financial institutions that do business with the country's central bank. Days later, Europe's leaders agreed in principal to an embargo on Iranian crude.

Of course, there are consequences to pushing the world's third largest oil exporter out of the energy market. If the sanctions work, crude supplies will get tighter. Meanwhile, Iran's military leadership, predictably irate the West's economic assault, has threatened to cut off a crucial oil shipping route in retaliation. If they do, it could send prices spiraling even higher. Are we heading for a new era $150 oil and a new global recession? It's a conceivable, if remote, possibility. Here is a basic primer on the volatile situation.

What do the sanctions do?
They cut off Iran's business partners from the U.S. financial system. But there are loopholes.

Under the new sanctions regime, any financial institution that does business with Iran's central bank, which is the conduit for most of the country's oil sales, will be cut off from the U.S. market. The law is intended to put a clamp on Tehran's more than two million barrels a day of crude exports, which provide its government as much as $81 billion a year in revenue. By gumming up Iran's flow of oil money, the U.S. hopes to weaken its economy and force the country's hard-line leadership to abandon its nuclear program.

The sanctions include a few important exceptions. First, they won't be implemented for six months, and then only if the White House determines there are enough alternatives to Iranian oil available to keep the world market stable. They also won't apply to banks based in countries that significantly reduce their oil purchases from Iran. Finally, the president has the power to waive sanctions if he decides it's vital to America's national security interests.

What are the odds that the sanctions will work?
Not great. Europe is on board, but there's no guarantee that China will cooperate.

For the sanctions to work, the U.S. will need help from much of the rest of the world. Depending on which countries cooperate with the U.S. plan, analysts quoted by the Wall Street Journal said that Iran's oil revenue could fall anywhere from 5% to more than 41%. But so far, the only clear signals have support have come from the European Union, which collectively purchases about a fifth of Iran's oil. Last Wednesday, Reuters reported that the EU's leaders had reached a preliminary agreement that would end those imports. The ban could be finalized at a meeting at the end of this month.

But Europe is just one piece of the puzzle. Courtesy of the BBC, here is a chart breaking down Iran's oil exports.

Screen shot 2012-01-09 at 9.12.05 AM.png

Asia, clearly, is the big variable. And the situation there is much murkier. This week, Treasury Secretary Timothy Geithner will visit Beijing and Tokyo, where he is expected to discuss the sanctions. Japan, along with India, is reportedly mulling ways to seek a waiver from the sanctions. True to form, China has been more outright defiant. On Monday, a government official told reporters that: "The normal trade relations and energy cooperation between China and Iran have nothing to do with the nuclear issue." But that only appears to be part of the story. With Iran's customer base shrinking, Chinese oil buyers are now demanding steep discounts. According to the WSJ, Iran's crude shipments to China are expected to drop 40% this month as the sides haggle over price. So China might not bow to U.S. pressure on sanctions, but it's not above using the situation to its own financial advantage.

If the sanctions go into effect, what happens to world oil prices?
They'll go up. Probably.

Tension over Iran has already coincided with the price of Brent crude rising to around $113, up about $7 since Obama signed the sanctions. If the U.S. is successful in rallying world support, it won't be a question of whether oil prices rise more, but by how much. Saudi Arabia -- which essentially functions as the world's oil merchant of last resort -- says it will increase its production to make up for any shortfalls created by the sanctions. But that move could have its own unfortunate repercussions. The oil markets like security, and Saudi Arabia's excess capacity is considered the ultimate insurance policy. Tapping its additional oil would use up that insurance, and could cause prices to spike. Per Reuters:

Saudi Arabia has said it is prepared to increase output in case of a sudden supply cut. But Commerzbank analysts said it is already producing 10 million barrels per day and spare capacity would be virtually used up.

"Given these developments, the risk premium on the oil price can be expected to rise further," they said in a note. "When spare capacities were last more-or-less exhausted in mid-2008, the oil price climbed to nearly $150 a barrel."

The more successful the U.S. is in pressing these sanctions, the more perilous it could become for the world economy. Will it drag us back into another recession? The White House's waiver powers are presumably meant to prevent that sort of calamity. But it's impossible to know.

What if Iran retaliates?
The world is ready to tap its extra oil reserves, but there's no telling how the market will react.

The flashpoint for this conflict could well turn out to be a narrow strip of water that separates the Persian Gulf from the Gulf of Oman and the Arabian Sea. The Strait of Hormuz is considered the the most important choke point in the global oil supply chain. About 20% of the world's oil passes via tanker through its two-mile-wide shipping channels. And if the U.S. enforces its sanctions, Iran has threatened to shut the waterway down. "If sanctions are adopted against Iranian oil, not a drop of oil will pass through the Strait of Hormuz," Iranian Vice President Ali Rahimi said in December.

It is possible that Iran is simply sabre-rattling in order to pump up oil prices before the sanctions take hold. But world leaders are taking the possibility of a blockade seriously. The International Energy Agency is reportedly discussing a plan to release 14 million barrels a day of oil from the world's strategic reserves in the event that the straits are closed. That would replace most of the 17 million barrels that traveled through them each day in 2011. The plan would tide the world over for one month. During that time, the United States would have to clear the straits using its own naval might.

It's possible that the release of strategic reserves would be enough to calm oil buyers and prevent a massive price surge. But in a military conflict over the straits, all bets would be off.

BONUS QUESTION: Why is this coming to a head now?
Congress decided it was tired of the Obama administration's Iran policy.

The Obama administration has been tussling with Congress for months over how best to deal with Iran's apparent desire to build a nuclear weapon. Back in August, a bipartisan group of 92 senators cosigned a letter urging Obama to hand down sanctions on the country's central bank. The White House resisted out of concerns that a unilateral attempt to cripple Iran's economy would alienate countries such as China and Russia, which do significant business with Tehran, and could destabilize the oil market.

The debate became more intense in November, after the United Nations' atomic watchdog issued a high profile report confirming that Iran has indeed been seeking to build a nuke. The Obama administration expanded its sanctions on the regime in response. But it wasn't enough to appease Congress, which tacked the new, harsher sanctions onto a $662 billion defense appropriations bill Obama signed as 2011 drew to a close.

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Jordan Weissmann is a senior associate editor at The Atlantic.

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