Middle East Economic Survey
VOL. XLIX
No 13
Will Iran’s Nuclear Standoff Cause A World Energy Crisis? (Part 1 of 2)
By A F Alhajji
This article was written for MEES by A F Alhajji, George Patton Chair of Business and Economics at the College of Business Administration, Ohio Northern University. He can be reached at a-alhajji@onu.edu.* Part 2 will be published next week.
I. Introduction
Iran, a founding member of OPEC, is the fourth largest oil producer and exporter in the world and the second largest OPEC producer after Saudi Arabia. Its oil production averaged 4.139mn b/d in 2005.1 However, its production has been declining since December 2005. Iran exported about 2.5mn b/d in recent months. Given its vast reserves of more than 125bn barrels2 and its relatively large volume of oil exports, it is no wonder that the dispute between Iran and the West over its nuclear program has put pressure on oil prices in recent months and increased their volatility. Prices rose every time negotiations broke down and Iran headed into a confrontation with the West. They decreased whenever negotiations yielded some positive results.
This dispute has revived predictions that oil prices will exceed $100/B if Iran retaliates by reducing its oil exports. On 22 January 2005, the AP quoted James Bartis, senior researcher at Rand Corp, as saying, “Even if Iran pulled a small amount of its oil off the market, say it pulled 0.5mn b/d, I could see oil prices literally jumping over the $100/B mark.” On 12 February 2005, Philip Bowring, a regular contributor to the International Herald Tribune, wrote about the possibility of Iran’s retaliation against air strikes on its nuclear facilities: “For sure, such action would drive the oil price over $100/B.” Iranian officials themselves, in a self-serving prediction, stated that oil prices would surpass $100/B if the UN imposed economic sanctions on Iran. On 23 September 2005, General Yahya Rahim Safavi, head of Iran’s powerful Revolutionary Guards, warned in a speech to worshippers attending Friday prayers in Tehran that “any sanction against Iran can make the oil price reach $100/B.”3
II. Market Reaction
The recent run-up in oil prices on the Iranian decision to stop negotiations and continue its nuclear program could continue through 2006. Oil traders fear that Iranian oil production might decline or come to a complete halt as a result of one or a combination of several possible scenarios:
1. The Imposition of Economic Sanctions: Iranian leaders may act on their threat and reduce oil exports if the UN Security Council (UNSC) imposes economic sanctions. Even if crude oil is exempted from sanctions and Iran does not reduce oil exports, traders fear that Iran’s output would decline within a few months on shortages of spare parts and a decline in foreign investment. Experience from Iran, Iraq, and other countries, indicates that a lack of spares would force the national oil companies to cannibalize some of their wells and equipment to maintain others, causing an output drop and permanent damage to the oilfields.
2. The Destruction of Iran’s Nuclear Facilities: Iran may retaliate by reducing oil exports if the US or one of its allies, especially Israel, attacks Iranian nuclear facilities with missiles from the US fleet or with an air strike. In this case, Iran would cut oil output to coerce Western governments supporting the US’s action to change their behavior, or to avenge the destruction of its nuclear facilities.
3. The Expropriation of Western Oil Companies: Even if Iran does not reduce oil exports, it may punish the countries that support sanctions or air strikes by revoking the concessions and agreements of their oil companies.4 Such action would not only increase tension between Iran and these countries and raise the probability of a disruption but would also reduce Iran’s production on the logistics of operation transfer to other companies. In the long run, it would reduce foreign investment in Iran’s upstream and block capacity expansion. However, the Iranian government may see an opportunity to focus on the IOCs, rather than production cuts, to force the companies to sign new contracts that are more favorable to Iran than the old buyback contracts that guarantee a certain return on capital regardless of oil prices.
4. Foreign Support of Arab Rebels in Khuzestan: Minority Arab rebels in Khuzestan might exploit the situation by accepting foreign support and escalating their attacks on oil facilities, which would also reduce Iran’s oil production. Tension has increased in recent months, and in September when a wave of attacks destroyed several pipelines in this oil-rich province.5
5. The Strict Enforcement of the Iran-Libya Sanction Act (ILSA): Although the act no longer applies to Libya, it still prohibits international oil companies (IOCs) from investing more than $20mn in Iran. The US has never enforced ILSA, which will expire in early August 2006. If the UN fails to enforce sanctions on Iran, the US may choose to enforce ILSA, both to pressure Iran to soften its stand, and also to pressure other UNSC members who do not support sanctions on Iran, namely China and Russia. In the short run, the impact on the oil market would be limited, but it would slow the growth of Iran’s oil exports over the next few years. The impact of ILSA would also depend on how China, Russia, Japan, and other countries reacted to the US’s action and how fast Asian and Russian companies that are not traded in the US stock market replace other companies. The US is able to enforce ILSA only on the IOCs that are traded in the US stock market or raise capital in the US.
The US’s concerns regarding Iran, ranging from nuclear proliferation to support for terrorism, will make it easier for Congress to renew ILSA, in one form or another, when it expires. The renewal will make ILSA available to US policy makers when it is convenient. In 2001, the Bush administration proposed extending ILSA for two years instead of five to allow more flexibility in dealing with Iran and Libya. The recent tension will most likely lead to a five-year extension. The political hype surrounding debate on the bill, and then its renewal, will add to market jitters in July and August, increasing oil prices and their volatility.
As this article was being written, three major developments occurred almost simultaneously. In early March, John Bolton, US Ambassador to the UN, reiterated Washington’s opposition to Japan’s investment in the Azadegan oilfield.6 On 15 March 2006, the House International Relations Committee approved the Iran Freedom Support Act. The legislation, most likely replacing ILSA, beefs up sanctions on foreign entities investing in Iran. The press reported that Japan’s oil companies stood to lose the most from the legislation. On the same day, Nippon Oil Corp, Japan’s largest refiner, said it would cut crude oil imports from Iran by 15% this year, citing increasing risk.7 Nippon insisted that the action was not politically motivated, but the decrease may not be related to reducing risk since it represents a very small percentage of Japan’s oil imports from Iran. Iranian officials said they knew about the reduction months in advance as the company plans a yearly overhaul of its refinery, thus forcing it to decrease its operations.
6. The Continuation of the Current Situation: Even this, traders fear, would increase market volatility and slow the growth of Iranian oil exports. Despite the deals that Iran has signed with IOCs in recent weeks, foreign investment may decline, especially since negotiations for the deals recently signed were in progress before the nuclear standoff.
Conflicting Signals Made The Situation Worse
Intended or not, the Iranian government made the situation worse by sending conflicting signals. While some ministers emphasized that Iran would not use oil as a weapon, others threatened to cut off oil supplies and reevaluate IOC contracts. A third group, the Supreme National Security Council, said that Iran had no plans to play the oil card at present but could do so if “conditions change.” Then, on 12 March, Reuters quoted Iran’s foreign minister Manouchehr Mottaki as saying Tehran would not use its abundant oil exports as a political tool and insisted that the oil option was not on the table. Strikingly, in a speech on energy and security issues in Tehran, he referred only to Asia: “The Islamic Republic of Iran is resolved to provide Asia with the energy it needs as a reliable and effective source of energy and will not use oil as a foreign policy.”8
On 8 March, before the OPEC meeting in Vienna, Iran’s oil minister Kazem Vaziri-Hamaneh asserted that Iran would not cut off oil production even if the UNSC imposed sanctions. On 14 March the same minister said, “If necessary, Iran will reconsider its oil contracts with other states.”9 On the same day, Hojjatollah Ghanimifard, executive director of international affairs at the National Iranian Oil Company (NIOC) stated: “We will not harm end-users of our crude oil by cutting exports.”10
III. Will Iran Pull The Trigger On The Oil Weapon?
The possibility of Iranian oil disruption is real given the level of tension between the US and Iran on one hand and the history of Iran in the last five decades on the other.
Level Of Tension: US View
The level of tension between the US and Iran is higher than most people think. From the US point of view, Iran has not only tried to acquire nuclear technology to build nuclear weapons, but has also supported terrorism. It financed Hizbollah’s operations in Lebanon, supported Hamas in Palestine, strengthened relations with Syria, interfered in the Caspian region, and intervened in Iraq. Iran refused to hand in or bring to justice several al-Qa'ida members. Despite elections, Iran has been controlled by a small group of supreme religious leaders who can even control the president. Human rights abuses are rampant. Messages of hatred and intolerance are common, including calls by President Mahmoud Ahmadinejad for the destruction of Israel in remarks that denied the Holocaust and termed it a “myth.”11 The recent dispute over Iran’s nuclear program is the last straw. Any US response would be to all of these concerns, not just to nuclear proliferation. The seriousness and the range of US concerns are so great that a disruption in Iranian oil exports is quite possible.
Iran’s View
The Iranian government believes the US and its allies have exaggerated the issue of its nuclear program, insisting the program is only for peaceful proposes. The Iranian government will not earn more prestige in the international community by developing nuclear weapons. Pakistan and North Korea certainly have not. As for security and deterrence, Iran does not have second strike capability, even if it has nuclear bombs.12 Iranian experts wonder why the US and the UK advised the Shah’s government to build nuclear plants to generate electricity when the Iranian population was around 30mn, oil production was around 6mn b/d, and Iran was energy sufficient, yet now they think Iran does not need these reactors when the population is over 65mn, oil production is only about 4mn b/d, and Iran has to import natural gas and petroleum products from other countries.13
The Iranian government believes that if it does not provide enough electricity to its growing population, its economy will stagnate, social tension will increase, and political turmoil will arise. Iranian experts say the population boom, with a high proportion of youth, and changes in culture and lifestyle in the last two decades have caused an unprecedented demand for electricity. The government has to choose between “domestic” security and “international” security.14 The choice is very clear. The government thinks it can handle international pressure. But it fears domestic pressure could bring down the regime. This logic is supported by the fact that the Iranian regime has survived a brutal war, economic sanctions, and massive international pressure. However, despite international support for the Shah’s government, domestic pressure forced him to flee Tehran in 1979.
On other issues such as human rights, terrorism, and involvement in Iraq and the Caspian, the Iranians see the application of a double standard in the accusations of the US and its allies. Why, for example, has Iran been deprived of its economic rights by more than two decades of economic sanctions? And why can Iran not intervene in Iraq when the US and its allies have already occupied the country? Why is Israel allowed to have nuclear bombs while Iran is not allowed even as much as a research program? For the Iranians, such issues are an integral part of their belief structure, making a compromise hard to achieve and raising the possibility of disruptions to Iranian oil exports.
Experts refer to Iran’s own history when they consider the possibility of oil export disruptions. Iran caused oil shortages in the early 1950s when Mohammad Mossadeq’s government nationalized the oil reserves: production halted when British oil workers departed. Subsequently, the UK imposed a ban on Iranian oil exports, saying any nation buying Iranian crude was acquiring stolen property. The UK took its case against Iran’s nationalization to the International Court of Justice in The Hague and lost. Iran also caused oil shortages in 1978 as the result of oil workers’ strikes, after the Iranian revolution in 1979, and after the start of the Iran-Iraq war in 1980. Although Iranian oil exports declined several times during the eight-year war with Iraq, the world as a whole did not suffer shortages. The markets were awash with oil at the time.
Will Iran Reduce Exports?
It is not in Iran’s interest to reduce its oil exports, let alone curtail them. Several economic and political factors should prevent Iran from using the oil weapon. An air strike on Iran’s nuclear facilities might give the Tehran government the public support needed to reduce or halt oil exports. But politicians know that such sentiment is short-lived, especially if the air strikes are not repeated.
History indicates that, since the 1979 revolution, the government of Iran has been long on words but short on direct action.15 For example, several Iranian leaders called on the government to pull the trigger on the oil weapon after the Jenin massacre in Palestine in 2002. Yet Iran continued to increase production. Some experts see it differently. They argue that the most important impact of the 1979 Iranian revolution was not the halt of output that occurred for a short period, but a decision by the government to cap output at 3.5mn b/d to prevent Iran adopting the lavish lifestyle that prevailed during the reign of the Shah. Those experts argue that the current hard-line government of Mahmoud Ahmadinejad may also think a decrease in production is beneficial to the Iranian people. However, we may see domestic economic and political pressure forcing Ahmadinejad to adopt a different view. Even Iranian experts point out that current political, economic, and demographic conditions in Iran differ greatly from those that prevailed 25 years ago.16 Iran’s population grew by 22.4mn people between 1980 and 2005 while oil output rose only by about 600,000 b/d.
Domestic Economic Issues
Iran is the only major producing country that still suffers from a budget deficit – recent reports indicate this might reach $12bn. The Iranian public is heavily dependent on state subsidies for staple goods and fuel. Social pressure and high expectations of young Iranians make the government vulnerable if it loses oil revenues. More than 90% of state revenues come from oil exports. The social pressure is so great that the government, to keep the peace, has no choice but to maintain subsidies, including those on housing and fuel. Even with record oil prices, the government withdrew $2.6bn from the Iranian Oil Stabilization Fund to finance the increase in spending in the 2005-06 budget.17 The fund was designed for use when oil prices decline, so the situation must be dire if the government needs to draw from it when oil prices are at record highs. As a result the government cannot afford a reduction in oil production or even a temporary halt in oil exports, especially when general unemployment is at 14% and at more than 20% among youth (although official figures are lower.)18
Much To Lose
Iran has much to lose if it cuts off oil exports, including:
Badly needed foreign
investment in its upstream sector. In the process, it would lose the support
of China and Russia. Even if upstream oil contracts with Western oil companies
continue, how will the latter, along with Chinese, Russian, and Japanese oil
firms, generate revenues if Iran does not export its oil? Most likely an
export cut-off would force companies to curtail planned investment in Iranian
oilfields. Iran needs all the capital and technology it can get, not only to
increase its production and oil revenues, but also to combat the natural
decline in its aged oilfields. Recent estimates indicate that it needs $1bn
investment a year just to avoid a decline in current production levels, and
about $1.5bn to increase its capacity.19 Given the current
macroeconomic situation, it lacks sufficient capital to make such an
investment. Even the present government is aware of this need. The latest
five-year economic plan allocates $70bn to the oil sector, with 60% from
foreign investment.20 On the political front, a reduction in
exports would hurt Chinese and Russian companies more than others. Russia and
China are the two UNSC members that Iran has been courting to avoid sanctions.
Long-term customers. Iran
learned the hard way from its nationalization experience in the early 1950s
that once you lose customers, it is difficult to bring them back.21
The worst thing for Iran today would be to be branded “unreliable” by its
long-time loyal customers. Since Iran sends more than 60% of its oil exports
to Asia, any production cut would hurt its allies more than its enemies.
Improvement in relations with
its GCC neighbors. Iran does not want to benefit the latter at its own
expense. A decline or a halt in Iranian oil exports would increase oil prices.
Arab countries would benefit from higher prices and increased production,
especially as Kuwait, the UAE, and Saudi Arabia will add more than 600,000 b/d
capacity in the next few months.22 Additional revenues will enable
some Arab countries to renew military capabilities and acquire new technology
that is much superior to that of Iran. The economic situation in the GCC will
improve while Iran’s deteriorates.
Support and the sympathy of
developing countries, covertly or overt, in its quest for nuclear power. An
Iranian oil exports cut-off might raise prices and hurt the fragile,
developing economies. And Iran cannot afford to compensate them with aid and
oil as some Arab countries did in 1974 after the oil embargo.
Control on domestic energy.
Iran might suffer from an energy crisis while its enemies would not. Iran
imports refined products, including more than 5mn barrels of gasoline per
month. Countries might retaliate by halting gasoline exports to Iran. A
decline in oil revenues might prevent Iran from importing gasoline and other
products, especially as it has to pay the world price, while it sells it to
the Iranian public at a subsidized one. The higher the world price, the larger
the subsidy.
Efforts to establish a
euro-denominated oil futures market in Iran, the Iranian Oil Bourse (IOB),23
constituting a big political blow to the current government and causing huge
financial losses.
The plan to build a 1,700-mile natural gas pipeline to India through Pakistan that would guarantee a long-term market for Iran’s gas and generate billions of dollars in revenues. The current hard-line government is keen on building the pipeline, even if India does not go along with the plan. However, Iran needs the growing Indian market and Indian political support.
Some experts may argue that a decrease in Iran’s oil exports would increase revenues, thus it would be in its interest to cut production. But a simple calculation shows that Iran would earn additional revenues from a production cut only if prices increased substantially. For example, in order to earn additional revenues from a 500,000 b/d or 1mn b/d export cut, prices would have to increase by more than $13/B and $34/B respectively. If Iran achieved such a revenue increase this way, it would be a first in history. For despite the loss of about 2mn b/d after the invasion of Iraq in March 2003, oil prices decreased. After Katrina, the world lost 1.5mn b/d and prices increased by only $10/B. Back in 1990, oil prices doubled within two months, but that was the result of a loss of about 4.5mn b/d of oil exports from Iraq and Kuwait.
No Benefits For Iran
In conclusion, Iran will not benefit from imposing an oil embargo on any country or group of them. The embargoes of 1956, 1967, and 1973 all failed to achieve their objectives – to coerce targeted nations into altering their policies toward Israel.24 Moreover, the 1973 embargo awakened nationalism among Americans who were willing to endure hardship rather than capitulate to Arab demands, viewing the oil embargo as a threat to their sovereignty, integrity, and way of life. The 1973 lesson applies today: a UN-sponsored embargo would not force Iran to comply; and a halt in Iranian oil exports would not force other countries to yield to Iran’s demands.
Iran’s leaders know well that they cannot inflict “pain” on the US and its allies through a halt in production. The US does not import oil from Iran so would not be affected, suffering only from high oil prices. The US and its allies can mitigate effects of an export cut-off by releasing oil from the SPR, with enough oil in strategic and commercial storage to compensate for a halt in Iranian oil for several months, while Iran would struggle to feed its own people. In an interview with French BFM radio, IEA’s executive director Claude Mandil said: “If ever, for whatever reason, there was a loss of supplies from Iran, which represent around 2.7mn b/d, strategic stocks managed by the IEA would be able to compensate for those lost 2.7 million b/d for a year and a half.”25
While it is not in the political or economic interest of Iran to reduce or cut off oil exports, the fear is that the Iranian leadership might overlook these factors and yield to short-term public sentiment. Some radical elements within Iran’s leadership might pressure the government to cut output in retaliation for UN-sponsored sanctions or an air strike by the US or its allies; or, as some experts assert, for the religious reason that excessive income will corrupt the Iranian people. If Iranian radicals fail to get their way, they could destroy some oil facilities to limit the options of the government and aggravate relations between Iran and the West. Furthermore Iran might pursue its policy of “indirect” confrontation and seek to halt Iraqi oil exports from Basra through its operatives in the area.
Notes:
* The author would like to thank Ed Morse and Robert Bryce for their insights and helpful comments. This paper is an outgrowth of the ideas that the author wrote in two columns for Gulf in the Media, an affiliate of the Gulf Research Center in Dubai, UAE.
1. Monthly Energy Review, IEA, 2006.
2. Oil and Gas Journal, 19 December, 2005.
3. “Iran Says Sanctions Could Push Oil to $100/B,” Forbes, 23 September 2005.
http://www.forbes.com/markets/feeds/afx/2005/09/23/afx2240812.html
4. The Iranian Oil Minister made such a threat on 14 March 2005. Countries that stand to lose the most in this case are France, Italy, the Netherlands, and Spain. European companies that lift Iranian crude include Shell, BP, Eni, Agip, Saras, Preem, Iplom, and Total. For more details see “Iranian 2005 Crude Exports By company”, MEES, Vol XLIX, No 8, 20 February 2006.
5. Several Iranian religious leaders accused the UK of supporting Arab rebels in Khuzistan. Several media sources reported that the US and its allies are planning to support the Iranian opposition, including the rebels in Khuzistan.
6. National Iranian Oil Company (NIOC) discovered Azadegan in 1999. A consortium of Japanese companies signed a buy-back agreement with Iran in February 2004 to develop the filed, which contains proven crude oil reserves of 26bn barrels. While initial production was planned for 2007, financial, and probably political issues as indicated above, have delayed the process. For more information see “Iran Country Brief,” EIA, 2006.
7. Reuters, 15 March 2006.
8. “Iran’s Foreign Minister Cools Oil Weapon Fears,” Khaleej Times, 23 September 2005.
9. “Iran Moves to Ease Oil Concerns,” BBC, 31 January 2006. http://news.bbc.co.uk/2/hi/business/4664590.stm
10. “Iran won’t use oil weapon to hurt consumers,” Oman Times, 15 March 2006.
http://www.timesofoman.com/newsdetails.asp?newsid=27159
11. His remarks were widely reported in the media. For example see CNN,
http://www.cnn.com/2005/WORLD/meast/12/14/iran.israel/
12. For more details see lecture by Mostafa Zahrani, a previous member of the Iranian Permanent Mission to the UN “Iran’s Nuclear Program: Fact and Fiction” at
http://www.american-iranian.org/pubs/aicupdate/03242005.html#zahrani
13. Ibid.
14. For example, see “Challenges to Security: The West Asian Experience”, a presentation by Mostafa Zahrani at the IDSA’s 8th Asian Security Conference: “Changing Security Dynamic in West Asia: Relevance for the Post 9-11 Systemic” 30 January – 1 February 2006. New Delhi, India.
15. While Iran has not been involved in a direct war with the US, Europe, or Israel, it has been involved in a sort of “cold war” through surrogates in Afghanistan, Lebanon, Syria, Palestine, Iraq, and the Caspian region. This policy suggests that Iran might retaliate against UNSC sanctions or US supported air strikes through its surrogates.
16. Ibid, Zahrani, 2006.
17. For details see: http://commentaries.kudlow.com/2006/2/23/kc022306.htm
18. The government announced recently that unemployment in the second half of 2005 stood at 10.9%. For more details see http://www.businessday.co.za/articles/world.aspx?ID=BD4A169184
19. “NIOC Undertaking Host of Projects to Boost Oil Output”, MEES, Vol XLVIII, No 19, 2 May 2005.
20. Ibid.
21. Alhajji, A F “The Failure of the Oil Weapon: Consumer Nationalism vs Producer Symbolism”, Bridges, Spring/Summer, 2004.
22. “Gulf Producers Dominate New Oil Production in 2006”, MEES, Vol XLIX, No 5, 30 January 2006.
23. For more on the establishment of the IOB see MEES, Vol XLVII, No 33, 15 August 2005.
24. Alhajji, A F “The Oil Weapon: Past, Present, and Future” Oil & Gas Journal, Vol 30, No 2, May 2005.
25. For details see IEA top stories at: http://www.iea.org/journalists/topstories.asp