Iran Sanctions and Oil Market Implications

Q: With tensions escalating between Iran and the West as both the United States and Europe prepare to impose additional sanctions, Iranian threats to close the Strait of Hormuz have driven up oil prices and sent purchasers scurrying to find replacement barrels. What is the likelihood of Iran following through on the threat, and what are the implications for the oil market?

A: Press reports indicate that the European Union has agreed in principle to impose an embargo on Iranian oil purchases, while President Obama recently approved legislation calling for the imposition of economic sanctions on companies and financial institutions that do business with Iran’s Central Bank. Details of the EU action will be announced on January 30, but already some member countries are resisting strict adherence to the measure or readying applications for waivers. Of the approximately 2.3 million barrels per day (mmb/d) of oil Iran exports, roughly 20 percent goes to European purchasers, with an additional 8 percent to Turkey. The overwhelming majority of Iranian oil is exported to Asian markets, including China, India, Japan, and South Korea. To date, U.S. allies Japan and South Korea have been active in attempting to line up additional sources of supply to at least partially offset reduced volumes from Iran. Getting China and India to go along will be a tougher sell but, if successful, could require Iran to discount its sales thereby further reducing oil-related revenues.

A combination of increased output from selected OPEC countries plus targeted use of OECD oil stocks could, for a period, offset any loss of Iranian crude volumes in the market place. But the resulting reduction in effective “spare” capacity would likely spook traders, as the loss of this excess production cushion would then no longer be available to cover any additional supply-related disruptions (e.g., Iraq, Nigeria, Syria, Yemen, etc.), and consequently result in increased oil prices at a time when the fragile global economy can ill afford additional price shocks. Additionally, shifts in crude flows will similarly require adjustments in regional and global refinery operations and refined product trade.

As for the Iranians following through on their threat to close the Strait of Hormuz—a critical oil chokepoint through which some 17 mmb/d of oil (20 percent of worldwide oil trade) and a third of the world’s liquefied natural gas (LNG) trade passes daily—most analysts regard such action as a low-probability (albeit high-impact) event for a number of reasons. For starters, Iran derives much of its revenue from oil exports, and closure of the strait would deny that nation (as well as its neighbors) a main evacuation route. It would also restrict the imports that Iran requires. From a geopolitical standpoint, closure of an international waterway would be certain to bring both political and military retaliatory actions that would further isolate the country politically and force current supporters, like China, to seek other energy sources at presumably higher costs. In short, closure would do far more damage to Iran in economic terms than the sanctions.

Of late, the range of contradictory pronouncements coming out of Iran indicates that fractures may be developing among the leadership, along with a loss of centralized decisionmaking authority. On the upside, this dispute could possibly lead to an opening for negotiations, although it is unlikely that any senior officials would agree to “trade” away the country’s prerogative to develop civilian nuclear power. That said, desperate nations driven to the brink sometimes do desperate and unpredictable things, and even if short lived, disruption to shipping in the Gulf would undoubtedly wreak havoc in oil markets.

Frank A. Verrastro is senior vice president and director of the Energy and National Security Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. David Pumphrey is a senior fellow and deputy director of the CSIS Energy and National Security Program. Guy Caruso is a senior adviser with the CSIS Energy and National Security Program.

Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

© 2012 by the Center for Strategic and International Studies. All rights reserved.

Frank A. Verrastro
Senior Adviser (Non-resident), Energy Security and Climate Change Program
David Pumphrey
Senior Associate (Non-resident), Energy Security and Climate Change Program
Guy Caruso
Senior Adviser (Non-resident), Energy Security and Climate Change Program