Sanctioning Iranian oil

With increasing geopolitical instability in oil producing states and the barriers that stand in the way of reaching a multilateral policy, the threat of sanctions in Iran only serves to intensify uncertainty surrounding oil price forecasts for 2012
Reyhaneh Noshiravani
19 January 2012

On 4 January 2012, in a striking expression of unanimity members of the European Union agreed “in principle” to ban the purchase of Iranian oil, with the aim of undermining Tehran’s nuclear programme.  

According to a European official "significant issues remain and no agreement is expected before the end of January." However, the precarious situation in the oil market, geopolitical instability in oil producing countries, limited prospects for international cooperation, and the EU’s own economic woes cast a shadow on the potential feasibility and efficacy of such sanctions.

Iran, which has the world’s second largest petroleum reserves, exports 2.5 million barrels per day (bpd), directing 450 thousand bpd of this supply to European member states, making the bloc collectively the second largest market for Iranian oil after China. If sanctions are imposed this volume must be sourced elsewhere, which would tighten supply and increase the price of oil.

Currently, geopolitical instability among oil producing states is applying pressure on the price of oil as markets attempt to assess the likelihood of supply disruptions in 2012. Last year, the Libyan revolution and civil war that toppled the regime of Colonel Qaddafi halted the country’s 1.3 million bpd exports. While production has been gradually increasing, it has yet to reach the pre-war rates.

This situation is only likely to be exacerbated as in some oil producing country the problems are just starting. In Iraq, resurfacing of violence following the departure of the last American convoy in December has threatened the stability of Baghdad’s national unity government and has flared sectarian tensions, placing the country on the verge of yet another civil war in less than a decade. Despite having the world’s fourth largest proven petroleum reserves, Iraq’s oil sector is constrained by the lack of investment resulting from years of sanctions and wars. Such developments could further undermine Iraq’s production targets by years.

In Nigeria, Africa’s primary oil producer, there has been a dramatic escalation of inter-sectarian violence bringing raising concerns about the possible emergence of a civil war. Moreover, a recent decision by the Nigerian government to remove gasoline subsidies has triggered protests and calls for strikes by trade unions. According to an oil analyst at Petromatix, “Nigeria, has a history of long strikes and that can have an impact on overall crude exports."

Only Saudi Arabia, the world’s largest oil exporter, is understood to have significant spare capacity, currently estimated at 2.5 million bpd. The Kingdom has announced that it is prepared to supply gaps should sanctions be imposed on Iran. However, pumping anywhere near the declared production capacity will be difficult to sustain and might involve extracting heavy crudes the market might not want. It would also be difficult to sustain higher rates for lengthy periods. Moreover, this could deplete Saudi Arabia’s spare capacity, which would ultimately fail to stabilize prices. Similar circumstances in 2008 increased the price of oil to almost $150 per barrel.

A further cause for concern is Saudi Arabia’s own domestic oil consumption, which according to a recent report by Chatham House is posing a serious threat to the Kingdom’s position as the world’s largest oil exporter. A reduction in oil prices is also unlikely to benefit the Kingdom’s domestic standing. As Mai Yemeni states “No kingdom is an island, particularly when it sits in a sea of revolution.” Saudi Arabia has not been immune to the democratic forces sweeping across the Arab world. Last years, pro-democratic protests were stifled through a massive show of force combined with a $35 billion financial aid package, which increased government salaries, subsidies and housing allowances, and payoffs to the religious establishment. The backbone of the increase in government spending has been high oil prices. Moreover, widespread public grievances remain, particularly among the Kingdom’s Shia population concentrated within the oil-rich eastern provinces.   

The efficacy of an embargo on Iranian oil is also dependent on the cooperation of Asian countries, which in itself would increase competition for Saudi Arabia’s spare capacity. Asian countries are currently Iran's principle costumers, and Tehran can offset the effect of European sanctions by boosting sales to Asian markets which have continuously demonstrated their preparation to absorb any incremental cheap supplies.

China, whose fast-growing economy is the world’s largest energy consumer obtained approximately 11 percent of its oil imports from Iran in 2011. Such huge imports would be next to impossible to obtain from other sources, and Beijing has already expressed its opposition to sanctions against Iran. On 4 January China’s Foreign Ministry spokesman Hong Lei stated, “China has consistently believed that sanctions are not the correct way to ease tensions or resolve the issue of Iran's nuclear programme… The correct path is dialogue and negotiations. China opposes putting domestic law above international law to impose unilateral sanctions on another country." China’s deputy foreign minister Cui Tiankai has repeated these sentiments. “The normal trade relations and energy cooperation between China and Iran have nothing to do with the nuclear issues” Cui told reporters, “We should not mix issues with different natures, and China's legitimate concerns and demands should be respected."  

For Japan, Iranian oil accounted for more than 9 percent of its energy needs in 2011. The Asian nation is now even more heavily dependent on oil and natural gas imports after last year’s devastating earthquake and tsunami forced the shutdown of its nuclear reactors. South Korea, which purchased 9.6 percent of its oil imports from Iran last year, is already seeking to be exempted from Iran oil sanctions.

European governments must also assess the implications of these sanctions for their own struggling economies. Several countries within the EU are heavily reliant on oil imports from Iran, and none more so than economically struggling Greece, which currently imports 30 percent of its domestic oil from the Islamic Republic. According to the rating agency Fitch, "The likely increase in oil prices that would result from a ban would be felt by all (European) oil refiners, not just those that are big customers for Iranian oil."

The imposition of sanctions against Iran's oil industry could possibly backfire by further radicalizing Tehran. An embargo against Iranian oil will likely be viewed as a hostile act and a direct threat to Iran’s national security. Iran earns almost $70 billion a year from oil sales, which is approximately 80 percent of its annual foreign revenue. Tehran has already threatened to stop the flow of oil through the Strait of Hormuz if foreign sanctions were imposed on its crude exports. Flows through this narrow strip of water that separates Oman and Iran are estimated at approximately 17 million bpd, or just under a fifth of global supplies. While the closure of the Strait would be a crippling blow to Iran's own fragile economy, such threats cannot be taken lightly. As Fareed Zakaria notes “weak countries whose regimes face pressure can sometimes cause more problems than strong nations.”

While debates continue on whether Iran has the will and capability to undertake such a risky endeavour, the uncertain atmosphere caused by these developments have increased market speculation, helping maintain oil prices above $100 a barrel despite sluggish global growth.

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