Iran Sanctions, the Strait of Hormuz and Oil Prices

David Fessler
by David Fessler, Energy & Infrastructure Strategist Natural Riches Natural Riches

Iran Sanctions, the Strait of Hormuz and Oil Prices

by David Fessler, Investment U Senior Analyst

Friday, January 13, 2011

On New Years Eve, President Obama dropped an "oil bomb." He signed legislation that effectively prohibits anyone who's doing business with the United States from doing business with Iran's central bank.

The intent of the law is clear: prevent Iran from completing any oil-related transactions, effectively using its abundant oil as a weapon against itself. That's a huge problem for Iran, since the revenue it gets from exporting crude fuels much of its economy.

Iran fired an "oil missile" back at the United States. It said that if boycotting its oil transactions was implemented, it would block the Strait of Hormuz to prevent shipment of any oil, Iranian or otherwise. Every day, about 14 supertankers pass through the Strait of Hormuz to fill up.

Would Ahmadinejad actually order his military to fire on one of these tankers? Highly unlikely...

The more likely scenario is that he has his six-shooters loaded, holstered and pointed at his own feet. Of course the mere threat of any conflict has caused oil prices to jump, and oil traders remain edgy at the prospect.

Who Loses if the Iranian Boycott Becomes Reality?

Who are the big users of Iranian oil? Here's the top four, according to data from Reuters:

  • Italy: 249,000 bpd
  • Spain: 149,000 bpd
  • Greece: 111,000 bpd
  • France: 78,000 bpd

Those top four importers account for about 23% of Iran's oil exports, estimated to be 2.5 million barrels per day (mb/d). How effective would a ban on Iranian crude be? Would the above countries immediately descend into chaos?

Probably not, but like everything with oil, it's not a simple answer. It depends on a number of factors, many of which are in a constant state of flux. Let's take a look at a few of the big ones.

Can Anyone Makeup a 2.5 mb/d Shortfall in Supply?

The Saudis say they can increase their 10 mb/d current output an additional 1 to 1.5 mb/d. But the real question is: Will they?

After all, they have a vested interest in keeping oil prices high. They're increasing their own spending roughly 7% annually to keep the average Saudi citizen happy. They don't want to become the next Arab Spring uprising.

Libya should be back at full capacity by the middle of 2012, about six months ahead of schedule. That's another 1.6 mb/d on the plus side. So even if Iranian oil exports were completely blocked, Libya and Saudi Arabia supplies alone could conceivably make up the difference.

Iraq is also returning as a major world supplier of crude. According to Hussain al-Shahristani, Iraq's deputy prime minister for energy affairs, Iraqi crude production is at a 20-year high of just over three mb/d.

Iraq is home to the world's fifth-largest deposits of crude oil and natural gas. Shahristani indicated that by the end of 2012, crude production will be close to 3.5 mb/d. By the end of 2013, he expects to have port loading facilities in place that will allow exports of as much as 3.6 mb/d.

Of course, this scenario assumes nothing goes awry anywhere else in the world. That's a big assumption. Nigerian rebels seem to take endless delight in blowing up oil pipelines. As much as 30% of Nigerian supply is offline at any given time.

The reality is, oil prices are set at the margins. That is, if a small amount of supply – as little as one million barrels per day - is knocked off-line for even a short period of time, it can (and will) have a profound impact on oil prices. Crude will quickly rise, as traders will leap before they have all the facts.

That impact is based more on perception and emotion than reality, as it turns out. History is ripe with examples of attempts to use oil as a weapon. Let's take a look at a few, and the results in the aftermath.

The Six-Day War

Also known as the 1967 Arab-Israeli War, it was fought between June 5 and June 10, 1967. Israel launched an attack against its neighbors: Egypt, Jordan and Syria. Israel launched missiles against opposition forces, and ended up taking control of the Gaza strip and the Sinai Peninsula.

Arab states discussed ways to punish the West in response to the air strikes Israel conducted on Egyptian targets. They agreed to suspend oil sales to the United States and Great Britain.

The embargo backfired, however. The Soviet Union, desperately in need of cash but flush with oil, agreed to fill the supply gap. The lost revenue was such a financial shock to the Arabs, the embargo was lifted after only a few days. The first instance of oil as a weapon was a dismal failure.

The Yom Kippur War

After the outbreak of yet another war in the Middle East, in October of 1973, the OPEC cartel decided it would nearly double the price of crude from $2.90 a barrel to $5.11.

It also indicated it would cut production by 5% until Israel withdrew from the areas it occupied from the war discussed previously. I remember this one, as it was only a few years after I started driving.

The reaction in Western nations was nothing short of an oil panic. Gas lines and rationing were common. Germany banned driving on Sundays. Fortunately, the gas lines weren't too long at the station near my house.

It turns out the fears over the embargo were greatly overdone, as the world remained well-supplied with crude from other sources. By December 1973, Saudi Arabia distanced itself from the embargo, and it crumbled just as quickly as it started. Using oil as a weapon failed once again.

Will it Be Different This Time?

The answer is: Probably not. Could we temporarily see $200 a barrel crude? You bet. But here's the reality: The world's oil supply is diverse and widespread. Don't be fooled: Producing countries are all in it for the money.

If Iran oil is blocked, the shortfall will be quickly made up from elsewhere. There will be two big losers in this latest oil war if an "oil bomb" is dropped on Iran.

The first will be Iran itself. Without its main source of revenue, it will be forced to comply or to appear to do so with the terms laid down by Western powers.

The other big loser will be the American and other gas-buying consumers around the world. We'll likely be paying sky-high prices for gasoline until the whole thing settles down. Here's hoping whatever happens, it doesn't last long.

Good Investing,

David Fessler

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