Possible Iran attack and potential oil shock

Published : 20 Jan 2014, 12:04 PM
Updated : 20 Jan 2014, 12:04 PM

In the midst of current Middle Eastern turmoil there is a possibility of attack on Iran's nuclear facilities by Israel with overt or covert US support. The threat has been hanging around for quite some time; recently due to negotiations between Iran and some western governments — it has reduced but it is still not off the table. There have been some media reports or rumours of meeting of minds between Israel and Saudi Arabia in this regard. Israel sees Iran as an existential threat since former Iranian president Ahmadinejad openly declared his desire to "wipe off" Israel from the world map. The new moderate Iranian president does not provide any confidence in the minds of hawkish Israeli politicians. Saudi Arabia takes a dim view of a nuclear armed Iran from Shia-Sunni conflict and regional domination/power play points of view. Iran has threatened to close the Strait of Hormuz in response to any attack on its nuclear facilities.

Background
Let's see how Iran fits into crude oil supply dynamics in the world market and then try to understand the importance of the Strait of Hormuz. We know that:

  • Iran has the fourth largest crude oil reserve in the world (151.17 billion bbl)
  • Iran is the fourth largest crude oil producer in the world (4.25 million bbl in 2010)
  • Iran is the third largest crude oil exporter in the world (2,523,000 bbl/day)

Due to western concern about Iran's nuclear ambition, it has been subjected to sanctions by the USA and the EU. It is led by the USA, which has targeted not only Iran's oil gas and petrochemical sectors but also the entire financial sector. The EU's sanction on oil purchases from Iran became effective on 1 July 2012. There are numerous media reports of India and China continuing to purchase oil from Iran using unconventional means, like barter trade, to evade USA sanctions. In October 2012, a dramatic fall of the Iranian currency, rial, has led to unrests in that country.

According to the US Congressional Research Service (March 2012)[1] 'The Straits of Hormuz is a key artery of the global oil market'. On average, 14 crude oil tankers pass through the Strait each day with 85% of these crude oil exports going to China, Japan, India and South Korea. The USA imports roughly 10% of its crude oil consumption through this narrow water corridor.

According to that report, apart from Iran, five other OPEC countries, (Iraq, Kuwait, Saudi Arabia, the United Arab Emirates and Qatar) shipped about 20% of the global oil market demand (equivalent to 17 million barrels a day) through the Strait in 2011. This region is also home to the world's spare oil production capacity (2–3mbpd) and there are inadequate alternate export routes; at best, 2–3 million barrels per day can be rerouted. If we assume that Iran decides close the strait; that is, 17 million barrels per day crude oil flow is blocked, the full 3 million barrels per day spare capacity is brought into action and the alternate route is fully utilised, but there will be still a shortfall of 11 million barrels per day. Other OPEC countries and non-OPEC countries will have to somehow come forward to meet this shortfall.

According to both EIA and the Congressional report, the USA has 696 million barrels of crude oil in 2012 in the Strategic Petroleum Reserve (SPR), and it is held by the USA government to offset supply disruptions. IEA countries have about 4.2 billion barrels of crude oil and refined products in inventory; one-third of the stockpile is in public hands. This is equivalent to 90 days' worth of net imports. The report says, 'If drawn down at the maximum rate technically possible, these government-held stocks could be delivered to the market at an average rate of 10.4 Mb/d of crude oil and 4 Mb/d of products in the first month of an IEA collective action, diminishing thereafter'. It means there will be a shortfall of 14 Mb/d–10 Mb/d = 4 Mb/d. The result will be panic in the market and instantaneous price increase. However, there are debates about Iranian reaction and as well as potential price increase.

According to the US Joint Chiefs Chairman, Dempsey Iran has the capability to block the Strait of Hormuz for a period of time. It has at its disposal 5,000 mines, a large number of small boats, three Kilo-class submarines, a dozen mini-submarines and several batteries of Chinese-made cruise missiles.

This congressional report and Meir Dagan, Former Mossad Chief (www.huffingtonpost.com, jpost.com) have hypothesized that Iran may not close the Strait. 'Rather than close the Strait outright, some experts believe that it is more likely that Iran would use the capabilities to disrupt, threaten, harass, and otherwise create substantial instability for shipping in the Gulf'. It will impact crude oil prices, which can lead to an oil shock.

Past oil shocks: 1973, 1979 and 1990

In the last 39 years, the world has seen three oil shocks due to geo-political events. The first was in 1973, during the Arab-Israeli war. OPEC imposed an embargo against the USA, Western Europe and Japan. Crude oil prices went from US$3/bbl in October 1973 to US$12/bbl in March 1974[2] (an increase of 400%).

The next oil shock occurred in 1979 after the Iranian revolution. Protests and strikes disrupted Iran's oil sector, production was curtailed and export stalled. The USA stopped importing oil from Iran; and Saudi Arabia and other OPEC countries increased their production to meet the shortfall (sound familiar?). According to Time Magazine[3] (1979), actual net production loss was 4%, but panic set in the market, and crude oil prices skyrocketed from US$15.85/bbl in April 1979 to US$39.50/bbl in April 1980 (an increase of 250%). This 'net production loss of 4%' is the most important datum to remember when hypothesizing about an oil shock.

The last oil shock was in 1990, after Iraq invaded Kuwait. Kuwaiti oil production stopped and Saudi oil installations were under threat. The price of crude oil spiked and it went from US$17/bbl in July 1990 to US$46/bbl in October 1990 (an increase of 270%). The duration of the oil shock was limited, but the impact on the global economy was nonetheless severe.

Roubini and Setser (2004) [4] have described the effect of the oil shock in a paper. According to them, 'Oil shocks have caused and/or contributed to each one of the US and global recessions of the last thirty years. Specifically:

* The 1974–1975 US and global recession was triggered by the tripling of the price of oil following the Yom Kippur war and the following oil embargo.

* The 1980–1981 US and global recession was triggered by a spike in the price of oil following the Iranian revolution in 1979.

* The 1990–1991 US recession was partly caused by the spike in the price of oil following the Iraqi invasion of Kuwait in the summer of 1990.'

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Rabiul H. Zaki is a BUET and AIT graduate currently working in Australia.

[2] 'Oil Price History and Analysis', WTRG Economics, www.wtrg.com

[3] 'Oil Squeeze', Monday, Feb. 05, 1979, Time Magazine. www.time.com

[4] 'The effects of the recent oil price shock on the U.S. and global economy' (August 2004) Nouriel Roubini & Brad Setser, http://pages.stern.nyu.edu/~nroubini/papers/OilShockRoubiniSetser.pdf