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Incoherent Thinking About an Iranian Oil Embargo

by Michael Levi
December 19, 2011

In the not so distant future – indeed perhaps only months from now – the United States and Europe may enact a mix of sanctions against the Central Bank of Iran (CBI) and Iranian oil exports as part of an effort to stall the Iranian nuclear program. Sanctions against the CBI would leave many current Iranian oil customers without any way to pay for their crude, effectively triggering a partial boycott on Iranian oil exports. Explicit sanctions would, of course, do the same.

This prospect has elicited a flood of market impact analyses. The ones I’ve seen are proprietary, so I won’t post or quote them here, but they appear to have one important thing in common. Parts of each analysis look country-by-coutnry to see who is currently most dependent on Iranian oil. They then suggest that those countries are at greatest risk in the event a cutoff. Other parts of each analysis estimate the rise in world prices that sanctions would provoke as a way of explaining how bad the consequences would be.

This is, quite literally, incoherent. To argue that each country will be affected differently depending on its level of imports from Iran, one must conceive of the world oil market as a place where geography matters deeply. This is inconsistent with thinking about a single world price for oil.

It’s easiest to understand this with an example. Spain imports roughly fifteen percent of its oil from Iran, while France imports only three percent. The first type of analysis I’ve cited would lead one to conclude that Spain would suffer more than France from an oil embargo on Iran. Since both countries import essentially all their oil, that would have to mean that they would experience substantially different oil prices. Think of it this way: if Spain needs to cut consumption by fifteen percent in order to balance its internal market, but France needs to cut its consumption by only three percent, Spain will need to experience a much larger rise in prices. This is, of course completely inconsistent with any calculation that treats the world as an integrated market with a single price.

If, on the other hand, Spain imports oil from France to balance its market (or buys oil that France would have purchased otherwise), leading prices to converge, then the fact that Spain was initially more dependent on Iran than France was will be irrelevant.

One can take this a step further. There is actually some reason to believe, at least in the short term, that a disruption in Iran could affect different consumers in different ways. (It can take time to rearrange shipping logistics and the like.) But for every country that is hurt more than a simple global calculation would suggest (because it can’t simply replace its supplies at the prevailing world price), there is another that doesn’t feel the full brunt of the disruption.

To see how this works, take another caricatured example. Let’s imagine that there are two suppliers in the world, A and B, each of which export one million barrels of oil each day, and two consumers, C and D, each of which import a million barrels a day. C buys its oil from A; D buys its oil from B. Now the world cuts A off entirely. There are two extremes at which one can analyze the outcome. In the first, markets are ultra-rigid, so C is toast. But in that case, D is sitting pretty, since it keeps importing the same amount of oil as before from B, and the market balances at the same price as before. In the second, markets are fully flexible. Both C and D reduce their consumption to half a million barrels a day each, splitting the total output from B. The world experiences a uniform price rise in order to trigger these cuts, and both countries suffer equally. The fact that C was importing from A before the cutoff is irrelevant.

Of course, one can imagine cases that lie in between these two extremes. Here, there is not one global price; C isn’t as badly damaged as in the first case, but it’s worse off than a simple global price estimate would suggest. D, meanwhile, is worse off than in the first case, but it’s better off than simple global price estimates would indicate.

What matters here is that simultaneously applying the two modes of analysis – one that makes geography central, and one that assumes it away – leads to incoherent results. If we want to really understand the likely impacts of an embargo on Iran, we need to square these two ways of thinking about the world, rather than pretending that they can coexist.

Post a Comment 3 Comments

  • Posted by Matt

    Any rise is absorbed as with a military strike it would take place at the low point of trade so any rise is say of $20 US barrel in the case of an embargo would see oil at same level at the close of trade. $80 dollars in the case of a strike would not see oil at $180 US a barrel but at $140 US a barrel as the timing is strategic. So if during a trading cycle oil drops to $80 US a barrel and we strike, at the close of trade oil would be $140 US a barrel. Israel will not strike via the moonlight but via the trading cycle at the low point.
    http://tfs.websol.barchart.com/chart.php?domain=tfs&page=chart&sym=CLG12&late=y&mode=i&jav=adv

    So with and embargo, a $20 US a barrel rise, as the UAE and Saudi Arabia can by-pass the straits of Hormuz as can Iraq. The Libya field was under developed under Qaaddafi, Iraq is back online. When have kept the crude price high to make shale and sand oil production fiscally viable as long as at the close of trade the price is between $90 to $100 US a barrel it is viable for Canada to maintain and increase production of shale and sand oil. Australia can increase production.

    So with a slight increase in production in the Mid East, Australia, Canada, Iraq back online, increased development of the Libyan fields demand can be maintained. Also due to the GFC people have less disposable income to spend on domestic petrol, which is one of the reasons OPEC has been able to maintain prices without increasing production. And we must not forget about Cabinda production increasing production and US offshore drilling increases. Which both Bush and Obama have pushed for because it is fundamental to implementing an oil embargo.

    Once Assad falls Iran will be cut out of the Iran, Iraq Syrian pipeline to the Med.

  • Posted by Matt

    I would like to add that the last round of UN sanctions allow us to conduct a quasi naval blockade in the Gulf of Oman. We can stop and search all Iranian bound and leaving Iranian vessels, proliferation. We can hold up these vessels for weeks, divert them to other destinations. We have then reversed the Iranian strategy back on them and basically closed the Straits of Hormuz. All shipping to Mid East countries can be redirected to other ports and supplied overland. Also just prior to Erik Prince leaving XE, we gave him the task of securing the Gulf of Aden from piracy with a naval embargo of the Gulf of Oman in mind. But he could not get approval from State.

  • Posted by David B. Benson

    How soon can Brazil pick up the slack?

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