Four Scenarios if Iran Oil Disrupted

 

 

       This scenario appears to be taking shape, as the United States enacts sanctions on Iran’s central bank and the central banks of those who purchase Iranian crude (though President Barack Obama can waive them), the EU implements an embargo on imports from Iran, and Japan and South Korea come under more intense pressure to reduce their imports of Iranian crude. These sanctions are designed to prevent global oil price spikes by keeping Iran’s oil flowing, but still forcing Tehran to sell at a discount to a limited pool of remaining buyers, including China, India, and Turkey, each of which has an economic self-interest in extracting a below-market price.

 

        In this scenario, global oil supply should remain unaffected, leaving physical market fundamentals largely unchanged, although that does not mean that prices might not respond in foreseeable ways. Spreads between different crudes would change according to their quality or region—for example, Russian export prices would likely rise as Urals crude could substitute for embargoed Iranian crude in Europe, while prices for heavy crude grades sold in Asia would fall as displaced Iranian barrels were diverted east. Average global crude prices should remain generally unaffected, though they may come under some upward pressure as market participants bid oil off the market to increase inventories as a precaution. Iran could also retaliate by storing crude on tankers for a few months or even stopping some production, which would increase global oil prices. However, many analysts believe Iran would resist a long-term shutdown of production because it would result in permanent damage to Iran’s oil fields and recoverable reserves.

 

       Despite officials’ efforts to avoid a supply loss, Iran’s threats and the perceived possibility of future escalation have and likely will continue to lead nervous traders to add an Iran premium to global crude prices. Iran’s leaders probably understand that a full-blown conventional conflict with the United States would be extremely costly, if not catastrophic. Making good on their threat to retaliate to sanctions by attempting to close the Strait of Hormuz is unlikely, unless Iranian leadership believes the regime itself is endangered; in any case, analysts generally believe that Tehran could not close the strait for an extended period of time.

 

        Short of a major confrontation, Tehran could escalate by harassing tankers in the region with mines, small boats, and missiles in order to raise global prices and possibly induce Russia or China to intervene diplomatically on its behalf to relieve pressure. Iran could also orchestrate bombings in the southern Iraqi oil production system, which normally exports about 1.7 mb/d.8 In October and December 2011, bomb attacks against the Rumaila field in southern Iraq reduced oil production by a significant 0.6-0.7 mb/d, albeit for only a brief time.

 

        Policymakers can address these real and perceived risks in several ways. Security in southern Iraq, especially the Basra Oil Terminal and tanks and pipelines associated with it, should be bolstered and preparations to defend the gulf and protect the Strait of Hormuz stepped up. False threats or reports of disruptions should be countered swiftly, but officials will need to walk a fine line between reassuring the market on the one hand and unintentionally spooking it on the other. Policymakers should recognize that adding a third carrier strike group to the region or conducting a test sale from strategic stocks might have the unintended consequence of scaring rather than reassuring the market, depending on prior perceptions of risk. The utility of these or similar steps would need to be based on an appraisal of actual and perceived risks at the time they were being considered. So far, the Obama ad- ministration has astutely countered panicky press reports and belligerent Iranian threats with calm reassurance and factual denials.

 

       It is also important for the International Energy Agency to forge and project member unity about when and how to use reserves. There was an unusual amount of public dissent among IEA members during the June 2011 stock release that IEA leaders should not wish to repeat. The IEA reportedly has recently reviewed standing plans for a 14.4 mb/d strategic stock draw over one month.

 

 

        If the United States and the world went beyond planned, limited sanctions aimed at diverting and discounting Iranian exports and instead forced Iran to halt all or most of its exports, crude prices would likely jump considerably. Some analysts expect prices would reach old highs near $140.11

 

        As noted earlier, market participants doubt that OPEC can offset the loss of Iranian crude and still leave a spare supply cushion. Depending on how quickly Iran’s oil was lost, prices would have to rise to balance the market by forcing consumption to drop. The short-term price elasticity of oil demand is low and could become even lower in a crisis as commercial stockholders sought to hold on to or increase the amount of oil in storage out of fear of a prolonged disruption. OPEC production increases could help isolate Iran politically but they are unlikely to reassure markets about supply availability. If officials wanted to offset the loss of Iran’s supply, they could turn to IEA strategic stocks, which could easily flow at a 2.5 mb/d rate, roughly equal to Iran’s exports, for many months or quarters if necessary. China, India, Thailand, and other non-IEA countries could be offered access to strategic stocks to prevent hoarding.

 

 

        A military attack by Israel or the United States on Iran’s nuclear facilities would likely lead to a sud- den price shock (about $23 per barrel in the first days should Israel strike according to a Rapidan Group survey of market participants) as traders priced in risk of a wider conflict. Subsequent price behavior would depend on market participants’ expectations of the likelihood and duration of a con- flict that damaged gulf infrastructure or blocked the Strait of Hormuz.

 

        IEA and OPEC policymakers would need to closely monitor gulf oil production and shipping in the hours and days after military action, while reassuring market participants about their ability to respond to any disruption.

 

        Assuming military attacks were limited to Iran’s nuclear sites and associated air defense and lasted a short number of days, contingency planning for strategic stock releases could be conducted quietly to avoid signaling alarm. But if the conflict escalated to include attacks against economic or leadership targets, or Iranian attacks on tankers or onshore oil facilities, IEA contingency planning could be more visible and the United States could undertake a test sale from the Strategic Petroleum Reserve (SPR) to reassure the market about IEA’s capability to offset a possible major loss of supply. The actual crude price effects of various threat scenarios and mitigation options depend on many variables and are difficult to predict definitively; policymakers will likely only know their effectiveness after they have been tried.

Short of attempting to block the Strait of Hormuz, Iran has other options to disrupt crude and liquefied natural gas (LNG) production and transportation in the gulf region. Using proxies or its own forces, Tehran could orchestrate attacks against energy facilities in Iraq, as previously noted, or attack Saudi or Qatari crude and natural gas export facilities. While much of the focus is rightly on oil, it should not be overlooked that Qatar exports about one-third of global LNG supplies.

 

 

       If a confrontation with Iran escalated to a regional military conflict that disrupted oil traffic through the Strait of Hormuz, it would be much harder for the IEA to handle, unless the disruption lasted on- ly a few days.12 About 17 mb/d flows through the Strait of Hormuz. Its closure, even for a short time, would dwarf any disruption in modern history in daily terms (see Figure 4). There may be some options to redirect some gulf exports away from the strait. Saudi Arabia could redirect 1.5 mb/d of production through unused capacity in the East-West pipeline to terminals near Yanbu, Saudi Arabia, which is on the Red Sea. A new United Arab Emirates pipeline, which bypasses the Strait of Hormuz, is expected to be ready to ship crude oil in the summer of 2012, and could provide an additional outlet for up to 1.5 mb/d.

 

        l just the fear of such a mammoth disruption will build a risk premium into crude oil prices and shift the market’s focus from OPEC’s spare capacity, which would be inaccessible in any case, to the strategic stocks held by IEA members.

 

        In the event of a major, prolonged disruption in Persian Gulf oil supplies, consumer countries trying to protect their economies from oil price spikes will face a menu of unappealing and inadequate options (see Figure 5 above). The most robust option would be a drawdown of strategic stocks, which the IEA claims could average 14.4 mb/d in the first month.13 On paper, the IEA could not cover the gross supply loss of 17 mb/d, but it could just about offset the net loss of about 14.5 mb/d, assuming 2.5 mb/d could be redirected through the East-West and Habshan-Fujairah pipelines.

 

        In practice, it is doubtful that 14.4 mb/d would be released in the first month for commercial, logistical, and policy reasons. In past releases, IEA countries delivered much less oil than was offered at first,14 as oil companies do not always take all the oil offered, depending on the price and each company’s market position. Moreover, a 14.4 mb/d release rate greatly exceeds any previous IEA strategic stock draws and, as with market estimates of OPEC’s spare capacity noted above, would likely be viewed by market participants with temporary skepticism. Additionally, releasing at maximum rates could signal panic that could incite increased private sector hoarding. Officials might want to conserve supplies for a potentially prolonged outage and other future contingencies. Furthermore, in the United States and some other IEA countries, the speed of strategic stock draws would be limited in the first month by bottlenecks in commercial inventories and previously scheduled import arrivals in the first week after the disruption. In those countries, strategic stock drawdowns into the commercial network cannot flow until the logistical system empties existing oil or the oil is diverted elsewhere.

 

        Despite these constraints, in the event of a worst-case regional conflict that results in a major supply loss, officials may well opt to “go big” by announcing a headline-grabbing 14.4 mb/d release. But it may be more credible to assure the market that the supply loss can and will be made up over time by higher OPEC production and from IEA stock releases. The most effective and credible way to limit and shorten the oil price spike will be for the military to quickly and convincingly reopen the strait to tanker traffic.

 

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