 | | Kip Beckman
Principal Research Associate,
Economic Services |
Our current economic outlook calls for only a modest increase in world oil prices from around $95 in 2011 to $100 this year – an increase that would not hurt the global economy. However, this projection assumes that the standoff between Iran and the West over oil shipments through the Strait of Hormuz does not spiral out of control. Unfortunately, given the unpredictable nature of the Iranian government, anything is possible.
The Iranian government continues to resist Western demands to close its nuclear program. This development has increased the possibility that Europe will follow through on its threat to ban oil imports from Iran. Not surprisingly, Iran has vowed to shut down the Strait of Hormuz in retaliation, which around 70 per cent of OPEC’s oil exports pass through.
Iran currently produces around 3.6 million barrels per day and exports 2.5 million barrels of this total. China is the largest importer of Iranian oil, followed by Japan, India, South Korea and Turkey. All European countries import 792,000 barrels per day from Iran – around 30 per cent of total Iranian oil exports.
In early January, the EU agreed in principle to embargo all purchases of Iranian oil starting in the latter part of this month. A complete embargo by the EU would displace around 600,000 barrels of Iranian crude, the majority of which is purchased by Italy, Spain and Greece. The Iranian government is currently trying to convince China and other countries in Asia to purchase greater quantities of Iran’s oil in order to make up for the shortfall. However, there is little guarantee that the European imports of oil from Iran could be redirected to these countries. Oil exports from Iran that are not purchased by other countries would effectively be removed from global oil supplies, a development that would naturally place upward pressure on oil prices.
The story does not end there, however. Saudi Arabia could decide to activate some of its excess oil-producing capacity that is currently idle and replace the Iranian oil taken off of the market. The Saudi government’s rationale for such a move would be avoid a spike in oil prices that sends the global economy spiralling into another recession, thereby choking off demand for Saudi crude. Under this scenario, higher demand for oil from the EU would be met by higher output from Saudi Arabia. The current global demand and supply for oil would be roughly preserved and world oil prices should remain fairly stable, although a political risk premium may be built into prices. Saudi Arabia’s oil revenues would increase, Iran’s would tumble and excess supply capacity of crude oil would be reduced.
Of course, this fairly optimistic outcome could be derailed if other countries decided to join the EU embargo and Saudi Arabia was not in a position to replace all the Iranian oil taken off global markets. In this situation, world oil prices could certainly increase.
A far greater concern for the global economy would arise if Iran followed through on its threat to close the Strait of Hormuz if the EU imposes oil sanctions. A disruption in the supply of oil passing through the Strait would have a major impact on global oil prices and economic growth. Let’s not forget that the global economy is already coping with the fallout from the European sovereign debt crisis and is not in a strong position to absorb sharply higher oil prices, which would simply add to the economic difficulties for oil importers such as Italy and Greece. Around 17 million barrels of oil per day travel through the Strait of Hormuz – equal to about 20 per cent of total global oil production. More than 85 per cent of this oil is destined for Asian markets.
If it acts, Iran would likely attempt to shut down the Strait by releasing mines and using naval vessels to harass tankers from pro-Western countries like Kuwait and Saudi Arabia. This was the strategy followed when Iran temporarily closed parts of the Strait in the mid-1980s. While US military presence in the region would quickly overcome Iran’s efforts to close the Strait, there would be costs. Even if oil tanker traffic were disrupted for only a few days, oil refineries in Asia would be forced to draw down their crude oil stockpiles. This would cause world oil prices to soar at a bad time for the struggling global economy.
Our latest global outlook assumes that Iran will not take drastic steps to shut down the flow of oil through the Strait of Hormuz, taking on US military might. The potential costs in terms of destroyed naval vessels and lost oil revenues would be simply too high for the fragile Iranian economy. More importantly, a move to close the Strait would provide a good reason for the West to try to destroy Iran’s nuclear facilities. But Iran is unpredictable and logic does not always guide its action.
Reference: Chris Lafakis, “Iran Threat Could Boost Oil Prices”, Moody’s Analytics (January 2012).