Will the Iran Sanctions Spark an International Oil Crisis?

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.

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Jordan Weissmann is a senior associate editor at The Atlantic.

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