Congressional Research Service: Iran’s Threats and Oil Markets

August 10, 2018

In response to the U.S. decision to withdraw from the nuclear deal and reimpose sanctions on Iran, President Hassan Rouhani threatened to block the Strait of Hormuz, a key waterway for the transit of oil and natural gas from the Middle East to world markets. Iranian leaders also threatened to disrupt oil shipments before sanctions were imposed in 2011 and 2012. Michael Ratner, an energy policy specialist at the Congressional Research published a report on the strait, Iran’s policy options and the potential impact on energy markets. “Due to its own dependence on commerce through the Strait, Iran may be unlikely to attempt to close the waterway, but rather to shape the international debate on Iran policy,” he wrote. The following are excerpts. 

 

The Strait of Hormuz

The Strait of Hormuz is the narrow waterway that forms the entrance to the Persian Gulf from the Gulf of Oman and ultimately the Arabian Sea. At its narrowest point it is 22 nautical miles wide and falls within Iranian and Omani territorial waters. There are two shipping lanes through the Strait, one in each direction. Each is two miles wide and they are separated by a two-mile buffer.

Hormuz

 

The United States and Sanctions

On May 8, 2018, President Trump announced that the United States would no longer participate in the Joint Comprehensive Plan of Action (JCPOA) and that all U.S. secondary sanctions suspended to implement the JCPOA would be reinstated after a maximum “wind-down period” of 180 days (November 4, 2018). The U.S. sanctions that are going back into effect target all of Iran’s core economic sectors. The Administration has indicated it will not look favorably on requests by foreign governments or companies for exemptions to allow them to avoid penalties for continuing to do business with Iran after that time.

It remains uncertain whether reinstated U.S. sanctions based on the U.S. unilateral exit from the JCPOA will damage Iran’s economy to the extent sanctions did during 2012-2015, when the global community was aligned in pressuring Iran. During that timeframe, Iran’s economy shrank by 9% per year, crude oil exports fell from about 2.5 million bpd to about 1.1 million bpd, and Iran could not repatriate more than $120 billion in Iranian reserves held in banks abroad. ...

Iran’s Perspective

Threats of U.S. sanctions that could reduce Iran’s oil export earnings is a key impetus to Iran’s threats to close the Strait of Hormuz. Historically, United Nations and multilateral sanctions had sought to reduce Iran’s ability to develop its nuclear program by undermining its ability to develop its energy sector—targeting investment and financial linkages—but not directly targeting Iran’s ability to export oil. This changed in 2012. 

Due to its own dependence on commerce through the Strait, Iran may be unlikely to attempt to close the waterway, but rather to shape the international debate on Iran policy. Oil exports are vital to the Iranian government’s fiscal health and the Iranian economy as a whole. Iran relies on the Strait not only for its oil exports, averaging about 2.2 million bpd in the first half of 2018, but also for the imports of some needed food and medical products. Iran could attempt to re-route imports through ports outside the Strait, such as Jask, or via established overland trade routes through Pakistan or Iraq. In 2016, the International Monetary Fund (IMF) estimated Iran’s oil exports account for between 50% and 60% of total exports and almost 15% of GDP. The latter shows that Iran has a relatively diversified economy. However, many experts see Iran’s warnings regarding the Strait of Hormuz as a reiteration of its long-held position to defend its oil exports. This implies that the likelihood that Iran might attempt to close the Strait increases if a broad embargo on purchases of Iran’s oil emerges, either from countries complying with U.S. secondary sanctions or reinstating their own. 

By threatening traffic through the Straits, Iran may risk alienating other nations, including its neighbors and customers, almost all of whom opposed the U.S. exit from the JCPOA and still want to engage economically with Iran. Most of the oil from the Persian Gulf, including from Iran, goes to Asian nations, with India and China being Iran’s largest oil customers. Within weeks of the United States withdrawing from the JCPOA and stating its intention to reimpose sanctions, India’s Foreign Minister Sushma Swaraj was quoted saying, “India follows only U.N. sanctions, and not unilateral sanctions by any country.” China has also indicated that it may not comply with the U.S. request to halt all imports from Iran. Turkey, Iran’s fourth largest oil importer, reportedly told U.S. officials it will not comply, as well.

Iranian Options Regarding the Strait 

Outright Closure. An outright closure of the Strait of Hormuz, a major artery of the global oil market, would be an unprecedented disruption of global oil supply and would likely contribute to higher global oil prices. However, at present, experts assess this to be a low probability event. Moreover, were this to occur, it is not likely to be prolonged. U.S. Secretary of Defense James Mattis asserted on July 27 that Iran’s doing so would trigger a military response from the United States and others to preserve the freedom of navigation in that waterway.13 The U.S. response could reach beyond simply reestablishing Strait transit.

Harassment and/or Infrastructure Damage. Iran could harass tanker traffic through the Strait through a range of measures without necessarily shutting down all traffic. This took place during the Iran-Iraq war in the 1980s. Also, critical energy production and export infrastructure could be damaged as a result of military action by Iran, the United States, or other actors. Harassment or infrastructure damage could contribute to lower exports of oil from the Persian Gulf, greater uncertainty around oil supply, higher shipping costs, and consequently higher oil prices. However, harassment also runs the risk of triggering a military response and alienating Iran’s remaining oil customers.

Continued Threats. Iranian officials could continue to make threatening statements without taking action. Alternately, Iran could conduct naval exercises in the waterway that raise tensions, whether or not any offensive action is planned. Cable News Network reported that the Islamic Revolutionary Guard Corps (IRGC) Navy, which is responsible for Iran’s defense of the Strait, plans a naval exercise in the Strait in early August, involving dozens of Iran’s small boats. The statements and maneuvers could still raise energy market tensions and contribute to higher oil prices, though only to the degree that oil market participants take such threats seriously.

Oil and Natural Gas Market Considerations

The Strait of Hormuz is a key route of the global oil market. Persian Gulf oil exporters—Iraq, Kuwait, Saudi Arabia, the United Arab Emirates (UAE), and Qatar—shipped almost 22 million bpd of oil and products through the Strait in the first half of 2018, which is roughly 24% of the global oil market.15 On average, 33 oil and LNGs tankers exited the Persian Gulf through the Strait each day with most of the crude oil and natural gas going to Asian countries, including China, Japan, India, and South Korea. According to the U.S. Energy Information Administration (EIA), the United States imported 1.7 million bpd of crude oil from Persian Gulf countries in 2017, less than 10% of U.S. consumption and no natural gas. Separately, about 28% of the world’s liquefied natural gas (LNG) trade, equal to about 3% of global natural gas consumption, moves through the Strait each year. 16 This primarily entails exports from Qatar to Europe and Asia.

The Persian Gulf is also home to the world’s spare oil production capacity. Some members of the Organization of the Petroleum Exporting Countries (OPEC), primarily Saudi Arabia, hold spare capacity as a result of their market management strategy. Kuwait and the United Arab Emirates hold small amounts of spare capacity as well. Spare capacity is viewed as a cushion to the oil market which can be used to offset supply disruptions. However, given its location, this spare capacity might not be available to offset a disruption to the Strait of Hormuz.

There are alternative oil pipeline routes to bypass the Strait, but not enough to account for all the oil that transits the Strait. According to EIA, there are three pipelines that transport oil from Saudi Arabia and the United Arab Emirates that go around the Strait—East-West Pipeline and AbqaiqYanbu Natural Gas Liquids Pipeline from Saudi Arabia, and the Abu Dhabi Crude Oil Pipeline from the UAE. As of 2016, when EIA last reported on these pipelines, the East-West Pipeline and the Abu Dhabi Crude Oil Pipeline could take additional volumes of oil, approximately 2.9 million bpd and 1.0 million bpd, respectively. This would leave approximately 18 million bpd stranded should the Strait of Hormuz be closed.

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