Iran and the 2012 Oil Market Outlook
As oil traders head home for the holidays, a flurry of Iran-related diplomatic and legislative activity is shaping what the oil market will look like when they come back to work in 2012. Last week the US Congress passed legislation that would sanction the Central Bank of Iran, the main conduit through which Tehran gets paid for its oil. President Obama will sign the bill into law by the end of the month and diplomats from the US, EU, Japan and Korea met in Rome this week to discuss its implementation, as well as a proposed EU embargo on Iranian oil imports up for consideration in January of next year. In this note we provide an overview of recent policy developments and a framework for thinking about the issue as it plays out next year. We find:
A new strategy for pressuring Iran: The old approach to Iran policy was to slowly reduce the country’s oil production by starving the sector of investment while giving oil exports a pass to avoid a price spike in international markets. In the wake of the November IAEA report, that approach has been thrown out the window. Iran’s oil exports are now a target. This change comes at a tough time for the global economy with oil markets tight and weak growth in Europe, Japan and the US.
Preventing an oil price spike is still a possibility: Despite their explicit focus on Iranian crude exports, US sanctions and an EU embargo can be implemented in a way that reduces Iranian oil revenue but doesn’t drive up global oil prices. A combination of increased non-Iranian production, redirection of discounted Iranian supply to countries that don’t comply with sanctions, and targeted SPR releases can mitigate price risk even if most Iranian oil customers stop buying during 2012.
The trick is in the implementation: Given the political and market environment in which this increased pressure on Iran is occurring, it’s unlikely everything will go according to plan. As a result, we expect a choppy oil markets thanks to Iran-related supply risks throughout 2012.
Taking Aim at Iranian Oil
For Washington and Brussels, the Gordian Knot of Iran policy is how to reduce the amount of oil revenue Tehran receives without driving up global oil prices. To date, policymakers have tried to untie the knot by slowing medium-term investment in Iranian oil production though financial sanctions while giving short-term purchases of Iranian crude a pass so the markets have time to adapt. This approach has had some success – the IEA projects that Iranian crude production capacity will decline from 3.87 million barrels per day in 2010 to 2.98 million barrels per day in 2016 due to a lack of investment (Figure 1).
Following the IAEA’s November report on Iran’s nuclear program, however, most US and European officials now believe Tehran will have the bomb by the time existing sanctions really start to bite. As a result, Iranian crude exports are no longer off-limits, indeed they they have become an explicit target. The alleged Quds Force plot to assassinate Saudi Arabia’s ambassador in the US and recent attack on the British Embassy in Tehran have further strengthened Western resolve to confront Iran.
Washington Looks for New Sanctions
Shortly after the IAEA report was released, the Obama Administration designated a number of Iranian entities as engaged in terrorism or nuclear proliferation. This finding makes any US or foreign company or individual doing business with them subject to a broad range of sanctions under the Comprehensive Iran Sanctions and Accountability Act (CISADA), including exclusion from the US financial system. The Administration stopped short of including the Central Bank of Iran (CBI) in the list, despite calls to do so from Congress, out of concern that such a move would roil oil markets. The US has already designated most Iranian commercial banks, forcing the bulk of Iran’s crude oil customers to settle their transactions directly with the CBI. Closing off this remaining payment channel as well could result in a significant disruption in Iranian supply. Instead, the Administration identified the country of Iran (including its central bank and the rest of the financial sector) as a jurisdiction of “primary money laundering concern” under section 311 of the Patriot Act, a move without direct sanctions implications.
Unsatisfied by the Administration’s actions and undeterred by the risk of an oil price spike, Democratic Senator Robert Menendez and Republican Senator Mark Kirk proposed an amendment to the National Defense Authorization Act on November 28th that would subject companies transacting with the CBI to US financial sanctions. In a rare show of bipartisanship, the amendment was adopted in a 100-0 vote. Last week, the National Defense Authorization Act, with the Menendez-Kirk amendment attached, passed both the House and Senate and will be signed into law by the President before the end of the year.
A more comprehensive Iran sanctions bill, the “Iran Threat Reduction Act”, is also working its way through the Congress. The legislation would significantly expand current sanctions on companies making oil and gas investments in or selling refined petroleum products to Iran. It would also officially designate the CBI as an entity engaged in terrorism and proliferation, exposing companies transacting with the Bank to a broader array of sanctions than under Menendez-Kirk, and limit the amount of flexibility the Administration has in implementing CBI-related sanctions (discussed below). The bill passed the House 410-11 earlier this month and will most likely be taken up by the Senate in February or March of next year.
Brussels Contemplates an Embargo
Following the IAEA report, the European Union joined the US in sanctioning additional Iranian companies and individuals, and the UK sanctioned the CBI. President Sarkozy, with British support, proposed an EU-wide embargo on Iranian oil imports shortly before the December 1stEuropean Council Foreign Ministers meeting. The French were unable to win support for an embargo at the meeting but the Council agreed to “broaden existing sanctions by examining, in close coordination with international partners, additional measures including measures aimed at severely affecting the Iranian financial system, in the transport sector, in the energy sector, measures against the Iranian Revolutionary Guard Corps, as well as in other areas.” The Council asked staff to further elaborate the range of options, including an embargo, analyze their impact, and report back to the Foreign Ministers in time for a decision to be taken at their January meeting.
Greece, Spain and Italy, the countries most dependent on Iranian crude (Figure 2), have indicated opposition to an embargo. While these three are not in the strongest negotiating position within the EU at the moment given their current fiscal challenges, it’s these same challenges that complicate their ability to switch from Iranian crude to alternative sources of supply. Greek refineries in particular have had difficulty buying on credit, prompting them to rely more heavily on the Iranians whose payment terms are more lenient. If an EU embargo does pass, we would expect a significant grace period for refiners to comply. US CBI sanctions, however, could render that grace period moot.
The Details are Vague but the Direction is Clear
There is a lot we don’t yet know about how the new US sanctions on the Central Bank of Iran will be implemented, or how they will be modified through additional legislation early next year. And it remains unclear whether the EU will proceed with an embargo or opt for a sanctions approach instead. Without this information, it’s difficult to predict what the precise impact of the increase in pressure on Iran will be. But as the overall change in policy direction is clear, we offer a framework for thinking about the potential oil market implications on the eve of what is promising to be an Iran-risk filled year.
A Challenging Market for Challenging Iran
Western governments’ new-found willingness to target Iranian crude comes at a difficult time for international oil markets and the global economy. Oil markets remain remarkably tight. Robust non-OECD demand and a range of supply disruptions have eaten through the spare production capacity and crude inventories built up during the financial crisis. Spare capacity in Gulf Cooperation Council countries (i.e. Saudi Arabia, Kuwait, UAE and Qatar – the OPEC producers with a meaningful ability to increase short-term production) is back near pre-crisis levels (Figure 3). And OECD crude inventories are back to where they were in 2007 and 2008 (Figure 4).
Tight physical supply has kept oil prices firm, even as global economic growth has slowed, with Europe, Japan and the US at risk of a double dip recession (Figure 5). And it’s not just the sweet light crude that Libya produces that’s in short supply, the heavier sour crude that Iran pumps (Table 1) is in increasingly high demand. Sweet light crude is easier to refine and thus traditionally trades at a premium to heavier and more sour crudes (see for example Figure 6 which shows the spread between sweet light Brent and medium sour Dubai). The financial crisis eroded that premium but the Libyan civil war sent refiners scrambling for replacement crude, pushing the premium back up to traditional levels. Yet while Libyan production has only partially recovered, strong demand for heavier sour crudes brought the spread back down over the second half of the year. In response Saudi Arabia raised output by 600,000 barrel per day (bpd) last month and has increased its Official Selling Price (the premium charged for Saudi crude relative to Dubai spot prices) to historically high levels.
In this market environment, a disruption in Iranian supply would have a significant impact on global oil prices. Table 2 lists Iran’s crude oil customers by volume and includes our estimate of the maximum potential impact on global oil prices if those customers stopped buying in the face of either US financial sanctions or a European oil embargo, as well as the resulting change both in Iranian government revenue and global oil expenditures.
We should stress that this is not what we think would actually occur should Tehran’s customer’s stop buying Iranian crude. There are a range of factors that can, and likely would, mitigate these price spikes – from an increase in non-Iranian output to a redirection of Iranian crude to other markets. We discuss these at length in the next section. The point of Table 2 is to highlight the potential risks to a global economy struggling to emerge from the financial crisis as Western governments tighten the screws on Tehran next year.
Even the lower range of the price increases shown in Table 2 would have a meaningful impact on the global recovery and would be particularly rough for Europe, the US and Japan. While our colleague Jacob Funk Kirkegaard is more optimistic than most on EU growth prospects – he expects a recession in the first half of next year, but a shallow one – a significant spike in oil prices would certainly change that outlook. It would also cut the legs out from under American consumers, who are just starting to show signs of life. Japan, however, would be the hardest hit, as the tsunami and nuclear crisis have not only delivered a body blow to the economy, but made it more dependent on both oil and oil price-linked natural gas.
Untying the Knot
While officials in the West are more willing to risk an oil price spike to pressure Tehran now than in years past, they would certainly still like to avoid the negative economic impacts described above. The good news is that there are ways to both reduce Iranian oil revenue without reducing global oil supply, even under the new, more confrontational approach. The bad news is that none are guaranteed to work, and they depend on the actions of policymakers and OPEC producers, both opaque to markets.
Rely on the Saudis
The US Congress and many European officials are counting on the Saudis to keep an Iranian oil embargo or financial sanctions from increasing global oil prices. Indeed, Saudi diplomats have been assuring policymakers, both publicly and privately, that the Kingdom will be more than happy to increase production to supply refiners that reduce their purchases of Iranian crude or stop buying all together. If true, this would be effective in limiting price increases – to a point. If reports on Saudi Arabia’s 600,000 bpd production increase in November are correct and sustained into 2012, the Kingdom will have the ability to increase production by an additional 1.8 and 2 million bpd, given the range of current forecasts for overall capacity. Drawing down spare capacity is not cost-free, as it reduces the buffer available for additional supply disruptions. A 500,000 bpd increase in Saudi production above current levels would probably not add much of a risk premium to global oil prices, but a 1 million bpd increase likely would.
Betting everything on a Saudi production increase is a risking gamble as the Kingdom has a history of breaking hearts in Washington and the bank accounts of oil traders around the world. Other GCC producers have roughly 500,000 bpd of spare capacity that could be tapped. And Angola and Iraq combined might be able to bring online 500,000 bpd above currently projected supply as well. Coordinated American, European and Japanese diplomatic outreach to these producers before the sanctions or embargo bite will increase the odds of mitigating an Iran-driven oil price spike.
Target Price Instead of Quantity
Iranian crude freed up by refineries choosing to comply with US sanctions or an EU embargo is not necessarily lost to the market. Tehran will no doubt attempt to sell that crude to buyers willing to ignore or able to circumvent Western pressure. And refiners in the countries least likely to join the US and European effort have the ability to absorb plenty of additional Iranian crude. China, for example, currently purchases over 2 million bpd of non-Iranian oil of similar quality to the stuff it buys from Tehran. With sufficient lead time there are no significant technical or transportation barriers to Chinese refiners and traders buying the full 1.2 million bpd of Iranian crude currently going to Europe, Japan and Korea (countries most likely to wind down their crude trade with Tehran) freeing up the same amount of Saudi, Omani, Russian and Iraqi crude for sale to Europe, Japan and Korea. There are certainly contractual, political and strategic considerations that could get in the way (we discuss these in the next section), but on a technical basis alone, there is no reason such a swap couldn’t take place.
Most Western officials would likely see this kind of swap as a sign that their sanctions or embargo policy has failed – responsible countries complied but China undercut the effort by stepping into the breach. This narrative is incorrect, particularly if the policy objective is to reduce Iranian government revenue while minimizing the global economic impact. Economic theory suggests that as the pool of customers willing to do business with Iranian shrinks, remaining buyers will be able to drive a harder bargain in oil price negotiations. We may in fact be seeing early evidence of this in the current dispute between Sinopec and the National Iranian Oil Company (NIOC) over 2012 supply.
If the effect of sanctions or embargo policy is to reduce the price paid for Iranian crude, rather than the quantity supplied, that’s potentially a better outcome for the US, Europe and Japan. Table 3 takes the estimates from Table 2 on the price and revenue impacts of a range of reductions in Iranian oil sales, assuming no redirection, increase in non-Iranian output or SPR release, and shows what level of price discount would be required if the dislocated crude was redirected rather than shut-in to achieve the same reduction in Iranian government revenue. A 23% percent discount on redirected Iranian sales to Europe, Japan and Korea, for example, would have the same impact on Iranian revenue as a loss of that supply all together (assuming no corresponding increase in non-Iranian production or SPR release). And global oil consumers would save $700 billion in the process.
The same effect could be achieved through an import tariff on Iranian crude. If applied by a majority of Iran’s oil customers, the tariff would force Tehran to reduce its sales price to remain competitive in those markets. As Iran is not a member of the WTO (though it has begun the accession process), there is nothing in international trade law that precludes Iranian oil customers from imposing such a tariff. It would, however, set a precedent that other producers (Saudi in particular) would likely find troubling, and could complicate efforts to increase non-Iranian oil production.
Tap the SPR
The third option for mitigating potential oil price increases resulting from a European embargo on Iranian oil or US financial sanctions is a coordinated release from Strategic Petroleum Reserves (SPR) in IEA member countries. In theory, these government-controlled strategic inventories could cover lost Iranian exports for at least a year, though the types of crude held and their geographic location means that in practice the length of cover would be significantly less. Also, any SPR draw in 2012 would need to be replenished in subsequent years, which would be constructive on 2013 and 2014 crude oil prices.
Managing the Process
The combination of increased non-Iranian supply, redirection of Iranian crude and targeted releases from the SPR is more than enough to offset the impact of plausible Iran-related embargo or financial sanction compliance scenarios during 2012. But it will require astute diplomacy by Washington and Brussels, and cooperation of the US Congress.
Most important is the time-frame under which the sanctions or embargo are applied. Increasing Saudi or other non-Iranian output, redirecting Iranian crude to other markets, and tapping the SPR all take time. Many Middle East producers, the Saudis and Iranians included, sell under annual contact. While the amount the buyer purchases is decided based on monthly nominations, the contract puts a band on how much the buyer can increase or decrease volumes each month relative to the contractually agreed amount. This isn’t a problem for refineries looking to buy more Saudi crude to replace Iranian crude – if the Saudis are willing to increase output the contract terms don’t really matter and Iranian contracts have force majeure clauses that could certainly be invoked. But if a refinery wants to sharply reduce their Saudi purchases to make room for discounted Iranian oil, and do so quickly, they may well face resistance.
Western diplomats will also need to send clear signals to other governments about what is sufficient in terms of cooperation. Redirecting Iranian crude to China, for example, and allowing Chinese traders to negotiate discounts with Tehran is a viable strategy for reducing Iranian government revenue while minimizing global oil price increases. But given the current rhetoric in Washington, Beijing sees such a move as a reputational liability rather than a way to support the cause.
Finally, Western policymakers will need to manage the discrepancy between national interest in oil-consuming countries and the self-interest of banks processing payments for Iranian oil trade. While an abrupt reduction in Iranian crude purchases would negatively impact the Japanese and Korean economies, continued purchases could be disastrous for the Japanese and Korean banks that facilitate the trade if it gets them sanctioned by the US. Presented with that risk, and in light of the relatively low business value of processing oil payments, these banks could decide to sever ties with Iran rather quickly, despite Washington, Tokyo and Seoul’s interest in gradual implementation.
The Menendez-Kirk Amendment is a mixed bag in terms of giving the White House the tools it needs to effectively manage the sanctions process. Sanctions don’t apply if the President determines that there is insufficient supply in global markets “to permit purchasers of petroleum and petroleum products from Iran to reduce significantly in volume their purchases from Iran.” The President can also make exceptions if the country of primary jurisdiction of the bank in question has “significantly reduced its volume of crude purchases from Iran”. Finally the President can waive sanctions if deemed “vital to US national security” or if he submits concrete evidence to Congress demonstrating what type of cooperation the Administration expects to receive in exchange for the waiver.
On the flip side, all three safety valves occur 90 days after enactment of the legislation and are based on market activity and the behavior of Iran’s trading partners during the prior 3 months. That’s enough opacity to give a risk-averse company or government incentive to start significantly dialing back their purchases starting day-one, even if doing so tightens oil markets. And the Iran Threat Reduction Act that passed the House 410-11 and will be voted on in the Senate in February or March of 2012 would remove much of Menendez-Kirk’s flexibility. We don’t yet know what will emerge from the European Council in January, but it could well be rendered moot if US sanctions are implemented in a way that convinces European refiners it’s time to wind down their Iran oil trade.
What Else Can Go Wrong
In addition to the limitations in the design of current and proposed US financial sanctions, there is plenty that could get in the way of Washington and Brussels’ ability to prevent the Iran issue from roiling oil markets next year.
Iran Plays Chicken
Tehran is unlikely to sit idly buy as Western policymakers scare away its buyers and its remaining customers demand steep discounts. NIOC is pushing back hard against Sinopec in current supply negotiations, demanding pricing comparable to the Saudis and quicker payment than they demanded last year. Given the precedent it will set for other buyers if Sinopec is able to bargain down the Iranians now, Tehran will likely choose instead to show the Chinese they are happy to withhold some supply for the first month or two of 2012 and wait for a better offer. Ultimately they will have little choice but to accept a discount, but it might be a messy process.
In the same vein, there is a non-trivial chance that Tehran will try to get out ahead of building international pressure and put in place an embargo of their own or interfere in the Straits of Hormuz in the hopes that the resulting price spike will break Western resolve. We see both as low-probability events, but they would have a significant enough impact on oil prices that they are worth taking into consideration.
Saudi Doesn’t Sell
The most significant risk outside of Iran’s behavior is that Saudi Arabia does not increase output to make up for any lost supply, as discussed above. While it would still be possible to avoid price spikes under such a scenario by displaced redirecting Iranian crude to China, the Saudis could get in the way of that as well by holding firm on their term contracts and warning Beijing of that any near-term reduction in Saudi supply will hurt long-term China-Saudi relations. Taking this tough of a line would risk driving prices up enough to prompt a double-dip recession, something the Saudis would like to avoid. But it could be a risk they are willing to take to both avoid burning through their remaining spare capacity or losing market share to the Iranians in China.
Election Year Politics
The Administration’s flexibility in implementing financial sanctions will be shaped by how Iran plays as an issue in the 2012 election. The Congress is already skeptical of the Administration’s commitment to pressuring Iran and would likely frown on some of the exemptions or waivers the President could issue. Most members, for example, don’t see an outcome where China increases its purchases from Iran but negotiates a discount as an acceptable, even if it’s an outcome that both reduces Iranian revenue and keeps oil prices stable. As such, giving China a waiver for such behavior would likely elicit significant criticism. And the Administration’s willingness to weather such criticism will be lower during an election year. As the guy who killed Osama Bin Laden, Barack Obama hasn’t given Republican presidential candidates much to run on when it comes to foreign policy. As a result, they have mostly focused on Iran, criticizing the White House for trying to “water down” Menendez-Kirk before it was adopted by the Senate. Issuing exceptions and waivers to the bill now that its law will provide the Republicans with useful campaign fodder.
China Doesn’t Buy
While Chinese officials disagree with Washington’s approach to Iran, Beijing is not immune to criticism and pressure. Leadership rightly believes that moves by Chinese companies to step into the breach and snap up discounted Iranian crude made available by compliant countries would be publicly criticized in the West. As discussed above, significantly reducing purchases of Saudi crude to make room for Iranian supply could also strain Beijing’s relationship with the Riyadh. This doesn’t mean China will turn away Iranian crude redirected from refineries in Japan, Korea and Europe. It just means they will need to balance the political and strategic costs of buying it against the economic and commercial costs of not, i.e. losing out on discounted supply and the global oil price increase that would result if that supply goes unpurchased.
A related concern is that China does increase the amount of Iranian crude it buys, but uses it to fill the country’s still-growing SPR rather than to replace Saudi or other medium gravity, high sulfur crudes in Chinese refineries. This would have almost the same impact on global prices as not buying the additional Iranian crude at all.
Sanctions Work too Well
The final implementation risk to oil markets is that the sanctions are effective in achieving what many of their proponents hope – a collapse of the Iranian economy. Under such a scenario, it’s not just the 2.5 million barrels per day of Iranian exports that are lost to global markets. All 3.6 million barrels per day of production could come off line, as occurred in Libya. Using Libya as a model, widespread civil unrest in Iran would also significantly curb domestic demand, but could still result in a net reduction in global oil supply of 2.9-3.1 million barrels per day. That translates into a 50-60% spike in global oil prices until increased OPEC output or an SPR release takes effect.
Estimates derived using price elasticities from the last five major supply disruptions in the Middle East and North Africa: the Yom Kippur War (1973-1974), the Iranian Revolution (1978-1979), the Iran-Iraq War (1980-1981), the Persian Gulf War (1990), and the Libyan Civil War (2011).