Middle East Economic Survey

 

VOL. XLIX

No 14

3-April-2006

 

IRAN

 

Will Iran’s Nuclear Standoff Cause A World Energy Crisis? (Part 2 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 1 was published last week. 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 the author wrote in two columns for Gulf in the Media, an affiliate of the Gulf Research Center in Dubai.  

 

I.  What Is The Impact Of A Production Cut On Oil Prices? 

It is not in Iran’s interest to cut off oil production under any circumstances, so it is unlikely that it will cut or reduce oil exports. Still, it was not in the interest of the US to invade Iraq, yet it did so anyway. It was not in the interest of Iran to reduce its production from 6mn b/d before the revolution to 3.5mn b/d after it, yet it did. Common sense does not always prevail. Iran’s leaders might overlook long-term consequences to garner short-term public support or achieve certain domestic religious goals. There are all kinds of possibilities and scenarios. For example, the government might announce an export cut just to calm the Iranian streets, even if it does not intend to cut exports. Several experts believe the aim of Arab governments that participated in the embargoes of 1956, 1967, and 1973 was to placate public opinion and curb the attacks of Arab nationalists against them.1

 

Even without a reduction in Iranian oil outputs, news of sanctions or an air strike would immediately increase oil prices by several dollars, but only for a short period. Panic would prevail until traders realized that oil supplies were abundant. If Iran in fact reduces its oil exports, the impact on prices will depend on specific factors:
 

1.         The amount of the cut. A complete halt or a cut that exceeds 1.5mn b/d would increase oil prices significantly. A small cut would have a limited and temporary impact, especially if OECD countries released oil from their SPRs.

 

2.         The volume of oil in floating storage and other storage facilities, including facilities that some OPEC members own in the Caribbean. There could be up to 9mn barrels in storage that companies could dispense within a few days, softening the blow of a sudden decline in Iranian output.

 

3.         The promptness of the US government and the IEA in announcing withdrawals from the SPR. Regardless of the debate regarding the effectiveness of the SPR, once traders believe the government will release oil from it in large quantities, this will force a cap on oil prices, even if no oil is released. Two reasons prevented WTI prices from exceeding their record of about $70/B last summer after Hurricane Katrina: a relatively more competitive world oil market that allowed speedy shipments to the US, and traders’ conviction that the IEA and US government would continue to release oil from the SPR if needed. The SPR announcement would be more effective if it included statements indicating that the release would continue until shortages were eliminated, without any reference to quantities.

 

4.         The OECD commercial oil stocks in terms of days of forward cover (demand and imports). The higher the number of days, the lower the effect of any production cut. However, it is difficult to determine such a number during periods of shortages or “crisis.” Higher oil prices may naturally reduce demand and imports, and increase the number of days that stocks can cover imports. On the other hand, higher prices may lead to stockpiling and hording, two of several responses that distort the numbers. Regardless, the impact of stocks on oil prices is a function of global excess capacity.

 

5.         The size of OPEC excess capacity. The extra capacity in OPEC would play a modest role, if any, in the first two weeks of the cut. It takes time to increase production. Since the quality of the remaining excess capacity does not match the most important portion of Iranian exports, OPEC excess capacity would not have the desired impact even a few weeks after the cut. However, the 1978-79 experience teaches us that any compensation from OPEC, even if takes time, would reduce the effect of a production cut by Iran, especially since distances to the main markets are the same. In other words, it takes more time to compensate for losses in production from the Gulf of Mexico because of the difference between the distance from there to the US and from the Middle East to the US. In case of a decline in Iranian output, the delay in compensatory shipments is limited to the time needed to increase production, not distance to market. The destination of the oil is virtually the same.

 

6.         Whether the cut or the decline is predicted or not. A surprise cut would have larger impact on the market than a predicted one. In fact, a well-predicted action would lead to a gradual increase in prices and then a decline. A surprise would cause a drastic increase within a very short time. Evidence from 2005 suggests that people are more responsive to sudden and large changes in oil prices than to gradual ones.

 

7.         Timing. The worst impact of a production cut would be during the two periods of peak demand in the winter and summer. Since demand declines by about 2mn b/d in the second quarter, any production cut by Iran in the next few weeks would have a limited effect – but the same cut would have a larger effect during the summer driving season in the US.

 

The worst-case scenario features the combination of a surprise cut-off of Iranian oil exports, little oil in floating storage and in the Caribbean, low commercial stocks in terms of forward cover, and a slow response by the US government and the IEA. A cut-off in this case would cause a loss of 2.5mn b/d, lowering commercial inventories significantly and increasing prices drastically, especially in the first few days. A surprise cut would increase panic and stockpiling, in turn exacerbating the situation and increasing prices further. In this case, the price would increase way above one reflecting only the physical shortage -- reaching new records. While it is impossible to predict the path of high oil prices, the experience of 1978-80 may provide some guidance, despite differences between that period and the current situation. Between January 1978 and January 1980, oil prices more than doubled, as shown in Figure 1. Iranian oil exports came to a complete halt in January 1979. The new government tried hard to increase output and exports, but the lack of experts, the US embargo, and then the Iran-Iraq war halted exports again. We cannot infer anything from the doubling in prices in 1979 without looking at other variables such as world excess capacity, the change in production in other countries, and inventories.

 

Compensating For Lost Output

In 1978, Saudi Arabia and several other countries compensated for Iran’s lost output. In 1978, between August and December, Iran’s production declined by 3.459mn b/d, from 5.84mn b/d in August to 2.39mn b/d in December. Saudi Arabia increased its production by 3.296mn b/d within the same period as shown in Figure 2. The other OPEC members increased production by 697,000 b/d, and non-OPEC members by 800,000 b/d within the same period. The fact that the increase in other countries’ production exceeded the loss in Iranian crude by more than 1.3mn b/d indicates the role of panic buying, stockpiling, and hording. These responses, accompanied by speculation and the inability of Saudi Arabia to add any additional production in 1979, led to higher prices.

 

Compensation for a reduction in Iran’s oil exports or a complete cut-off requires less excess capacity today than was needed in 1978. Iran’s current oil exports are only about 2.5mn b/d and its total production is about two-thirds of what it was before 1978. OPEC members have at least 900,000mn b/d of excess capacity that can replace Iran’s oil. Data from various producing countries indicate that these will add more than 1mn b/d in new capacity in the next few months.2 This increase, accompanied by lower demand growth, would mitigate the effect of any long-term decline in Iranian exports on prices.3 For this reason alone, Iran cannot inflict “harm and pain”4 unless it cuts off its oil exports completely. A reduction would have little impact on the market.

 

Despite the recent increase in the level of OECD commercial oil stocks, they are still relatively low in terms of demand and import cover. Current forward demand cover stands at 51 days, less than the 52 days during the invasion of Iraq in March 2003, the 54 days during the invasion of Kuwait in August 1990, the 60 days during the Iranian revolution in January 1979, and the 57 days during the oil embargo in October 1973. In the US, the current demand cover of commercial stocks stands near 51 days. While this number is higher than that during the invasion of Iraq (44.4 days), it is several days lower than the demand cover during the Kuwait invasion, the Iranian revolution and the oil embargo.5 Current commercial stocks forward cover of US oil imports is about 82 days, slightly higher than the 80 days during the invasion of Iraq in March 2003. However, this number is in no way near the 142 days of import cover during the invasion of Kuwait, the 132 days during the Iranian revolution, and 162 during the oil embargo of 1973.

 

By historical standards, commercial stocks forward cover of demand and imports in OECD or in the US is low. This is not the case when the strategic petroleum reserves are added to the picture. For example, the US crude stocks forward cover of imports, including the SPRs, is significantly higher now than that between 1978 and 1980, as shown in Figure 3. Current US total crude oil stocks cover 50% more days than they did in the late 1970s. The US SPR was only 91mn barrels in 1979 – now it is about 680mn barrels. However, that is not the case for commercial crude oil stocks. Current commercial stocks forward cover of imports is similar to that at the beginning of 1979, during the Iranian revolution. Therefore, only a prompt commitment by the US government and IEA members to use the SPR can mitigate the effect of a decline in Iranian exports. It is worth noting that the above facts regarding the SPR and commercial stocks indicate that there is some sort of substitution between the SPR and commercial stocks, which limits the role of the SPR in enhancing energy security.

 

The opposite scenario would not include a production cut, but would see calls by Iranian leaders to cut off oil supplies or impose embargoes. It also would include demonstrations in the streets of Iranian cities demanding that the government use the oil weapon. As mentioned earlier, oil prices would increase on panic buying and stockpiling that followed the news of UN sanctions or an air strike, even if Iran did not cut production.

 

Several Possibilities

Between these two scenarios lie several possibilities. These include a selective embargo on exports to some European countries or revocation of the licenses of European oil companies operating in Iran. Oil embargoes, in general, would not have an effect on the market unless they were associated with a production cut. Selective embargoes do not work. At the same time, if a selective embargo was associated with a production cut, it would punish friends and foes alike. The impact of a selective embargo without a production cut would be limited to panic buying and stockpiling.

 

The most likely scenario would not involve a decrease in Iran’s oil exports for the reasons cited above. However, the Iranian leadership’s need to put pressure on Western countries might force it to do something that hurts them, such derailing US and UK plans in Iraq. Iran might act to cut off Iraqi oil exports in the south. In this case, it would achieve its political and economic goals, putting pressure on the US and its allies on the one hand, and earning extra – and badly needed – revenues from the increase in oil prices on the other. Under such a scenario, the cut-off of Iraqi oil exports would reduce world oil supplies by about 1.1mn b/d.

 

Statistical analysis indicates that, all other factors being equal, a loss of Iraqi oil exports would increase oil prices by an average of only $4.50/B in the first month, with an initial spike immediately after the cut. A complete halt of Iranian oil exports would increase prices by an average $19.70/B in the first month, with an initial spike in the beginning. These projections assume that the US government and the IEA did not release oil from the SPR. The price increases would be lower if SPR oil was released. Given today’s prices, theoretical and empirical evidence do not support claims that oil prices would exceed $100/B if Iran decided to reduce or cut off its oil exports. However, the reader should not infer from the above numbers that the loss of both Iraqi and Iranian oil would increase prices only by the sum of $4.50 and $19.70 – such a development would change the whole picture and increase prices by more than this.

 

The impact of a decline in Iranian or Iraqi exports would have a moderate impact on oil prices in 2006. On average, the maximum impact from the loss of all Iraqi oil exports would be less than $5/B and less than $20/B from the loss of all Iranian oil exports. Prices would increase sharply immediately after the production cut, but decrease soon thereafter. A combination of SPR releases and an increase in OPEC production would cover any amount of cuts. An IEA-coordinated SPR release would add 2mn b/d to the market. Within four-to-five weeks, the rest of OPEC members could add about 900,000 b/d – and adding new production capacity through the year, amounting to an additional 1mn b/d.

 

However, if Iran cuts off its oil exports, light crude premium will increase substantially. Neither the SPR nor OPEC can compensate for all the lost Iranian light crude. Prices of petroleum products will ease if the premium is large enough to entice refiners to make gasoline from heavier crudes.

 

II. Conclusion

Action by the UN or the US and its allies against Iran would increase oil prices by a few dollars on the fear that this might reduce or halt Iranian oil exports. Prices would go even higher if Iran retaliated and reduced its oil exports. Nevertheless, it is unlikely that Iran would do so. It is not in its interest, under any scenario, to decrease exports, let alone to halt them. However, domestic pressure, a sense of nationalism, and the need to improve its bargaining power with Western countries might force the Iranian government to retaliate. Given the high economic and political costs of using the oil weapon, Iranian operatives in Iraq might cripple Iraqi oil exports from Basra, rather than reducing Iranian oil exports. This option, reducing world oil supplies by about 1.1mn b/d, would hurt US and UK plans for Iraq, while boosting Iran’s oil revenues.

 

Given Iranian resentment over buyback contracts, UN sanctions or an air strike might provide the Iranian government with a golden opportunity to revoke the contracts of Western and Asian companies and force them to leave Iran or sign new ones that are more favorable to Iran. The impact of this on Iran’s oil production would be moderate since many of these contracts are related to fields under development. The maximum decline in exports in this case would be about 500,000 b/d. However, it would be a gradual decline.

 

The impact of a decline in Iranian oil exports or a halt of Iraqi oil exports would be limited and much less than some experts have predicted. Statistical analysis indicates that a complete cut-off of Iranian exports would increase oil prices by about $20/B. If the impact was limited to a cut-off in Iraqi oil exports, the psychological impact on the market would be less than that of a similar reduction in Iranian exports. Evidence suggests that traders have been accounting for a possible complete halt in Iraqi oil exports since 2002. Most of the impact would be limited to panic buying, stockpiling, and speculation. In this case prices would increase by an average of $4.50/B. The use of the SPR and an increase in OPEC production would prevent prices from increasing substantially.

 

Use Of The SPR

The current level of commercial inventories of forward demand cover indicates that these would not serve as a cushion in the event of a decrease in Iranian or Iraqi exports. Therefore, the first line of defense in the short run is to use the SPR. A prompt response by the IEA and the US government to release oil from their SPRs, given the credibility that the SPR gained after Katrina, would cap prices and prevent them from rising substantially, even if governments did not release the whole announced amount. The use of the SPR would also lower speculative demand and force prices down. However, if the SPR was not used, a cut-off in Iranian exports might bring back backwardation to the market.

 

If the decreases or the cuts lasted for more than few weeks, OPEC production would increase slightly and mitigate some of the effect of an Iranian/Iraqi production cut on prices. If the production cut lasted for several months, output from new projects in OPEC, accompanied by a decline in demand growth, would balance the market by the end of 2006.

 

Side effects from a UN embargo that might affect world oil markets and increase prices include a lack of investment and a shortage of spare parts, slowing oil production growth in Iran. A more immediate effect would be the impact of UN sanctions on Iranian-Caspian oil swaps. The world might lose a small volume of oil (slightly more than 60,000 b/d) if Kazakhstan, Turkmenistan, and  Azerbaijan, under pressure from the UN and the US, stopped the swap that allows Iran to use Caspian oil in the northern cities and Tehran, and export a similar amount from its fields on the Gulf. If the three Caspian countries could export that oil Iran would have no choice but to reduce exports by the same amount and divert them to the affected area. The impact of halting the swap on the oil markets would be both to reduce exports and create havoc in logistics. Another possible side effect is an energy crisis in Iran if countries halted their gasoline exports to it.

 

Regardless of what happens, it is clear that an Iranian nuclear standoff would not cause a new global energy crisis, but would increase prices and market volatility. The seasonal decline in the second quarter would make any production cut during this period almost absolute. Most of the impact, under most scenarios, would be from panic buying, speculation, and stockpiling, rather than large physical shortages of oil. In the long run, the impact of the Iranian nuclear standoff would be limited to a decline in the growth in Iranian exports.

 

Consumers’ Reaction

What can consuming countries do in the event of a decline in Iranian oil exports? We have learned an important lesson from the 2005 Hurricane season: free markets work, especially if governments limit their policies to correcting market failures. A combination of government action and inaction mitigated the impact of the hurricanes on oil and products prices. The IEA’s decision to release 60mn barrels from the SPRs of its members, including the US, and the suspension of specific environmental regulations in the US, contributed to increased supplies. These actions also increased US gasoline imports and put downward pressure on crude and products prices. At the same time, federal and state governments rejected calls for price controls and direct intervention in pricing. This “inaction” allowed market forces to work. Therefore, a decline in Iranian or Iraqi oil production would not cause an energy crisis; but government intervention to control fuel prices would definitely make it a “crisis.”

 

In the event of outright war between Iran and the US, all bets would off. In fact, it might lead to a cut-off of both Iranian and Iraqi oil exports and the reduction of oil shipment through the Hormuz strait. Aside from panic buying, most of the increase in oil prices would be related to the inability of Saudi Arabia and its neighbors to ship oil to world markets, and very high shipping insurance premiums. Again, the best policy response would be to limit government intervention to SPR releases, while allowing free markets to work. Governments can make corrections for market failures by various measures – but none should include price controls.

 

Notes

1. Daoudi, M S and M S Dajani. “The 1967 Oil Embargo Revisited” Journal of Palestine Studies, Vol 13 No 2, 1984.

2. “CGES: OPEC Capacity to Rise 1mn b/d This Year,” Oil & Gas Journal, 6 March 2006.

3. In their March monthly reports, both OPEC and the IEA revised their forecasts for world demand growth downward. A further increase in oil prices will enforce this trend and reduce demand.

4. Several media sources reported on 8 March that Iran threatened the US with “harm and pain” if the UN Security Council was used as a new and potent lever to punish Iran for its nuclear program.

5. IEA and OPEC Monthly Oil Reports, 1990-2006.

 

Figure 1

Iran’s Crude Oil Production vs. Oil Prices

 


Source: EIA, 2006.

 

 

Figure 2

Production Of Iran And Other OPEC Members During The Iranian Revolution

(‘000 B/D)

 


Source: EIA, 2006.

 

 

Figure 3

US Crude Oil Stocks Import Cover (days) Vs Oil Prices ($/B), 1973-2006

 


Data Source: EIA, 2006.