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The Real Oil Shock

An Iran with nuclear weapons is the true threat to the world economy.

Jan 16, 2012, Vol. 17, No. 17 • By MICHAEL MAKOVSKY AND LAWRENCE GOLDSTEIN
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In 1993, James Carville, President Bill Clinton’s political strategist, said that “if there was reincarnation,” he’d like to return as the bond market, because then he could “intimidate everybody.” Today, with interest rates historically low, the fantasy of choice would no doubt be to come back as the oil market, which intimidates even the U.S. government. 

Photo of cargo ship

Cargo ships in the Persian Gulf in December

EPA / ABEDIN TAHERKENAREH / LANDOV

Fear of the oil market and its impact on the fragile U.S. and global economy is seemingly a driving factor in the Obama administration’s Iran policy. The administration cited that fear in opposing and then weakening legislation that would sanction Iran’s Central Bank and in belittling the prospects for a U.S. military attack on Iran’s nuclear facilities. While the administration is right to be concerned, it should take a longer view. A fuller analysis of the oil market suggests that allowing Iran to develop nuclear weapons capability would produce higher oil prices for a longer duration than would either action taken to prevent it. 

On December 1 the Senate voted 100-0 in favor of legislation sponsored by Senators Mark Kirk and Robert Menendez that would sanction companies that deal with the Central Bank of Iran (CBI). A primary purpose of the legislation was to undercut Iran’s oil exports, which are financed through the CBI and supply more than half of Iran’s state revenue. This was a notable achievement. Many considered CBI sanctions the “nuclear option” of sanctions and the best possible, and perhaps last available, means short of military action to prevent a nuclear Iran. The administration, however, opposed this legislation, partly out of concern that it would reduce the supply of oil in the market, driving prices up and undermining the fragile global economy—this at a time President Obama is focused on reelection. 

The administration managed to persuade the bill’s authors to weaken the legislation, which finally passed both congressional chambers on December 15. Obama signed it on December 31. It gave the president greater discretion over whether and what sort of sanctions to impose on financial institutions dealing with the CBI. Sanctions would take effect six months after the legislation is signed into law. The president can grant exemptions to financial institutions whose parent countries are cooperating with U.S. policy toward Iran, and can waive sanctions altogether if it is “in the national security interest” of the United States. The administration must inform Congress bimonthly whether there is sufficient non-Iranian oil supply to allow foreign buyers of Iranian crude to reduce their purchases from Iran significantly. There is another round of potentially tough sanctions legislation that could pass this spring, which includes sanctioning the CBI if it is determined to be supporting Iran’s weapons of mass destruction or terrorism. 

For these sanctions to exert any meaningful pressure on Iran, international support will be crucial since American companies already do not purchase Iranian oil. Instead, almost three-quarters of Iranian oil exports in the first 11 months of 2011 were purchased by four countries: China (27 percent), India (18 percent), South Korea (12 percent), and Japan (16 percent). The European Union bought only a little more than India (22 percent), with Italy the largest buyer (8 percent). Only if the four main Asian buyers stop buying Iranian oil will Iran’s revenue truly suffer. If these Asian countries do not reduce or cease their oil purchases from Iran and some European countries do (those countries now indicating support for an import ban account for 5-12 percent of Iranian oil exports), Iran will be forced to sell more oil to Asia. With greater leverage, the Asian buyers will likely demand a discount. This will reduce Iran’s oil revenue but not enough to force Tehran to cease its nuclear program. 

The administration reportedly has already asked these Asian countries to reduce their Iranian oil purchases. The Saudi oil minister has said, and his country’s oil production numbers confirm, that they will provide what their customers and the market need. A former senior Obama administration official has said the Saudis have offered to make up for some of the Iranian supply. (Saudi Arabian oil is comparable to Iran’s and could mostly replace it—in contrast to the very high-quality Libyan oil lost during its recent civil war, which was irreplaceable and led to a spike in oil prices.) U.S. requests have largely gone ignored, though South Korea is reportedly considering reducing or stopping its import of Iranian oil. 

The CBI sanctions law does provide the Obama administration greater leverage in its discussions with other countries, but probably not enough. Other countries know that the Obama administration is loath to implement the sanctions fully, not only because it is concerned about oil prices but also because severing relationships with foreign banks that hold U.S. bonds could disrupt the U.S. financial system. 

To convince Asian buyers to reduce or cease their purchases of Iranian crude, the administration will need to arm itself with more than the CBI law and Saudi oil. Senior Obama officials will need to make it abundantly clear that the only alternative to sanctions is a U.S. or Israeli military strike on Iranian nuclear facilities. In other words, the choice offered should be: Reduce/cease purchase of Iranian oil to pressure Iran enough so that its nuclear threat can be resolved peacefully, or face the real risk of having the oil supply from Iran and the Persian Gulf disrupted for some time following military action. 

Instead, the administration has gone out of its way in public to express its opposition to an Israeli military strike and condition the American public—as well as Iran, China, and others—not to expect a U.S. strike. Despite repeated assertions that they are keeping “all options on the table,” Defense Secretary Leon Panetta has followed the practice of his predecessor Robert Gates in highlighting the risks of a military strike. Twice recently, Panetta emphasized a strike’s “unintended consequences.” He listed five categories of them in a speech on December 2, including high oil prices, which the Washington Post criticized in an editorial entitled “The Wrong Signals to Iran.” Panetta and Obama have since strengthened their rhetoric, but the damage was done. Indeed, the administration has not made any credible preparations, at least overt ones, such as military exercises and deployments, for a strike. 

Thus, as long as the administration continues to derogate publicly a military option against Iran, CBI sanctions are unlikely to be adequate. By publicly eschewing a military option by Israel or the United States, the administration has undercut the chance for CBI sanctions to work and inadvertently made war more, not less, likely. 

This is certainly the case regarding an Israeli attack. Israeli officials have suggested that CBI sanctions are the last chance to prevent peacefully a nuclear Iran. An Israeli attack would indeed lead to a spike in oil prices, the duration and extent of which would depend upon the nature and intensity of the Iranian response. Iran could retaliate against Israel with missiles and have its Lebanese terrorist proxy Hezbollah rain down many of its 50,000 rockets upon central and northern Israel, including Tel Aviv. Still, Iran might be constrained from expanding its target area lest it invite an American response. An Israel-Iran conflict could last a few days or a few weeks, during which tankers could avoid loading oil from Iran or southern Iraq. Oil prices would certainly spike during such a conflict, and that rise could be sustained afterwards if there were damage to Iran’s oil facilities. 

If the United States attacked Iran’s nuclear infrastructure, the attack would likely be more sustained and more intense than an Israeli strike, and the theater of conflict would cover a larger area, leading to a higher and longer spike in oil prices. A U.S. attack would also likely inflict a lot more damage on Iran. The United States could employ its vast air and naval assets to fire missiles and drop bombs that would cripple not only Iran’s nuclear infrastructure but also its defensive and offensive military capabilities. Iran could react ferociously, knowing it had less to lose than if responding to an Israeli strike alone. It could try to disrupt the flow of oil from the Strait of Hormuz—using mines, gunboats, missiles, and so on—to prevent its enemy neighbors from exporting oil and to raise the cost of the military action and increase international pressure on the United States to cease its actions. The Iranians could also attack the oil facilities of Saudi Arabia and other neighbors that were supporting the U.S. strike. The duration and extent of that impact could depend on the magnitude, if any, of the damage to energy facilities of the Persian Gulf countries, particularly Saudi Arabia. The United States and other major consuming countries could mitigate the rise in oil prices by releasing their strategic reserves, but the spike in oil prices would still be significant. 

However great the impact on oil prices of military action to address the Iranian threat, it could be relatively minimal and short-lived compared with the sustained period of higher prices that would result from Iran passing the nuclear threshold. This would create longer-term economic damage to the United States. 

Consider first the potential consequences of a nuclear Iran. It could set off a proliferation cascade across the Middle East, with Saudi Arabia leading the way in acquiring nuclear capability. Iran would also be in a position to transfer nuclear materials to its terrorist allies. Further, Iran would seek to dominate the energy-rich Persian Gulf emirates and the Organization of Petroleum Exporting Countries (OPEC), threaten Israel’s existence, destabilize moderate Arab regimes, subvert U.S. efforts in Iraq and Afghanistan, embolden radicals, violently oppose the Middle East peace process, and increase support for terrorism and proxy warfare across the region. Former undersecretary of defense Eric Edelman, Andrew F. Krepinevich Jr., and Evan Braden Montgomery argued in Foreign Affairs that Israel and Iran could each have incentives to strike the other first with nuclear weapons. Similarly, Ambassador Dennis Ross, who recently served as a senior Mideast official in the Obama White House, explained that in such a situation the “potential for miscalculation” would be “enormous.” It is likely that some sort of conflict could emerge in the region involving both nuclear powers, which could drag in the United States. The U.S. position in the region, including the perception of its ability to secure the Strait of Hormuz, would plummet. 

All these potential consequences would heighten risks for the secure and sufficient supply of oil from the Persian Gulf, made worse by rising Iranian strength in OPEC and the need of major energy-importing countries, primarily in Asia, to deal delicately with Iran. The result would be a long-term rise in oil, gasoline, and heating fuel prices that would have serious negative implications for the fragile U.S. economy. Oil prices reflect many factors, including transit costs, current supply, projected future supply, and demand. Transit costs in turn include insurance premiums, which vary with the chance that vessels could be damaged or lost. The political risk to delivery is another factor; even without nuclear weapons Iran already has raised oil prices by threatening to close the Strait of Hormuz. In short, supply and transit projections reflect consideration of risks, and such risks would be tremendously heightened if Iran developed nuclear weapons. To begin to assess the economic consequences, consider that roughly every $10 rise in annual oil prices produces a nearly 0.5 percent decline in U.S. gross domestic product. 

It is impossible to predict how the Iranian crisis will play out. The most desirable but least likely scenario is an elegant resolution that inflicts no short-term economic sacrifice on the United States. If the crisis gets resolved through tough sanctions or military action, the economic pain could be significant but relatively short-lived. The worst prospect both strategically and economically is a nuclear-armed Iran. The United States needs to prevent that from developing for both security and economic reasons. 

Michael Makovsky, a former oil analyst at investment firms, is director of the National Security Project at the Bipartisan Policy Center and author of Churchill’s Promised Land.
Lawrence Goldstein is a founder of the Energy Policy Research Foundation and former consultant to the office of the secretary
of defense.

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