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Oil Market Policy Options in a Confrontation with Iran

by Blake Clayton
February 1, 2012

Wall Street has been busy thinking through what might happen to oil prices (and the global economy) if conditions worsen in the Strait of Hormuz. Various scenarios could unfold, from mild to dire. But an equally important question has escaped similar close scrutiny: What options would policymakers in the U.S. and other IEA member countries have to confront a massive disruption to oil supply in the Persian Gulf, and how should they select from among them?

A new Energy Brief from CFR’s Project on Energy and National Security addresses those questions. Written by Bob McNally, the president of Rapidan Group and a former White House senior energy advisor, the article presents four oil market scenarios that might develop in a confrontation with Iran and assesses the options that policymakers would have for mitigating any adverse oil market consequences.

McNally sees five major policy options, which are not mutually exclusive and each only a highly imperfect substitute for a well-functioning market:

-Allow supply losses to be absorbed by demand destruction resulting from an oil price spike.
-Accept a drawdown from private consuming country (OECD) stocks.
-Encourage OPEC to increase production that does not flow through Hormuz.
-Put in place production surge and demand restraint measures in IEA countries.
-Coordinate a drawdown of IEA strategic inventories (SPRs).

These options differ sharply in mechanism, feasibility for Washington to impose unilaterally, and likely effectiveness in keeping a lid on oil prices. The first one doesn’t require any action at all, but could have catastrophic consequences for the global economy if the disruption proved long and severe.

Last year’s drop off in Libyan oil exports was a reminder that while geopolitical interruptions to the smooth functioning of the market can materialize in a number of ways, OECD policymakers face a limited menu of options when oil comes off the market unexpectedly. Still, even their blunt tools for managing the market, skillfully applied, can considerably lessen the economic damage of a supply rupture.

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