How to Choke Iran Without Killing the World Economy

The U.S. is trying to punish Tehran with sanctions without sending oil prices skyrocketing. That means Iran needs to keep selling its crude -- but for cheap.


The United States would like to perform a magic trick, and our economy might depend on its success. The illusion? We want the world to think Iran's oil is practically a Las Vegas McMansion.

Now, nobody is going to confuse a barrel of crude with a four story desert abode. Las Vegas houses have been widely shunned and practically unsellable. As a result, their prices have plummeted for the few remaining buyers. We want the same thing to happen to Iran's oil: We want it to become so unpopular that Iran is forced to sell it only at a significant discount.

Perhaps it seems odd that the United State should hope Iran sells any of its oil. After all, we're using sanctions to turn Tehran into a pariah within the global financial system, making it next to impossible for them to actually export crude, with the hope that it will force the country's leaders to drop their nuclear program. But you can't cut the world's fifth largest oil producer entirely out of the global petroleum market and not expect prices to surge even more than they already have.

Instead, our government wants Iran to keep shipping oil to some of its major customers -- but for cheap. "Policymakers need to ensure that they are not creating an embargo of Iranian oil but, instead, implementing these sanctions so that Iranian oil becomes a distressed asset," Foundation for the Defense of Democracies Executive Director Mark Dubowitz, who advised Congress while it drafted the sanctions legislation, told Bloomberg today.

Translation: The the sanctions are not designed to take Iranian oil off the market. They are designed to limit the country's customer base, giving buyers a stronger hand in bargaining. Ideally, that would cause the price of Iran's oil to fall -- just like mortgage backed securities (or Las Vegas McMansions) have become nearly worthless "distressed assets" in the wake of the financial crisis -- and starve its government of much needed revenue.


This is a smart strategy in theory -- a sort of Goldilocks approach to foreign policy. The sanctions can't be too light, or Iran will just continue on its merry way enriching uranium. But they can't be too harsh either, or the world will need to find a replacement for several million barrels of oil a day.

A new report from the Energy Information Administration released yesterday, which is intended to inform President Obama's decision on whether to enforce sanctions during the coming months, shows just how troublesome that hole in the market would be. It estimates that in February, the world used 500,000 more barrels of liquid fuels, which include oil and replacements such as biofuels, than it produced. Take Iran out of the math, and it used 3 million barrels a day more than it produced.

The world does have the ability to pump more crude, thanks mostly to Saudi Arabia's massive resources. But the cushion is shrinking. For the last two months, OPEC countries averaged about 2.5 million barrels a day of total spare oil capacity, down from about 3.7 million a year ago. Tapping into it any further would likely cause prices to rise. Oil traders view spare capacity as an insurance policy against unanticipated events -- a revolution in Libya, or a civil war in Syria, for instance. When that insurance policy gets cashed, the cost of oil goes up, as shown in the graph below.


Even with Iran in the game, the oil market is extremely tight. Without Iran, it would be in crisis. And replacing Iran's oil with Saudi crude is only half a solution.

Luckily, Iran seems to be doing everything within its power to continue its exports, even if it has to take haircut on price. There are reports that the country has been resorting to barter deals, such as offering oil for rice and bananas. If true, that's a situation the U.S. will be happy to live with.