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Asia vulnerable to oil shock in Strait of Hormuz

Asia’s increasingly energy import dependent economies would suffer the worst of the fallout

Fears of an oil shock brought on by a conflict or natural disaster in the Strait of Hormuz, the oil market’s most important artery, have long preoccupied Western oil executives and policymakers. Now, though, it is Asia’s increasingly energy import dependent economies that would suffer the worst of the fallout in another Middle Eastern oil crunch. Yet the region remains unprepared to deal with such an upheaval.

As the centre of the global oil market has shifted east over the past decade, so too have the risks. However, while the West has taken the hard lessons of the 1970s oil crises and developed a robust system to help it weather another potential disruption, Asian governments have not followed suit. “The growing interdependence between the Middle East and Asia has shifted global oil security East of Suez, reaching beyond the OECD and related IEA oil security institutions,” warns John Mitchell in a new Chatham House report, Asia’s Oil Supply: Risks and Pragmatic Remedies.

At the core of the report is a scenario in which a disruption in the Strait of Hormuz results in the sustained loss of 10 million barrels a day (b/d) from the market. It is an extreme and unlikely scenario, not least because the US military would move swiftly to re-open the waterway. But the exercises shows just how vulnerable Asian countries would be to such an upheaval and how unprepared the region is to react to a major supply disruption.

The West’s dependence on Middle Eastern oil has, in recent years, been replaced by Asia’s dependence. In 2012, Mitchell shows, 75% of the Middle East’s oil exports went to Asia, making up 50% of the region’s demand. By contrast, less than a quarter of exports went to the US and Europe and those region’s now count on the Middle East to meet less than 15% of demand.

Most of that oil, about 90% in 2012, flows through the Strait of Hormuz, a narrow passage that links the Gulf and the Gulf of Oman. It is one of the oil market’s most vulnerable chokepoints. Roughly half of all the oil consumed in Asia in 2012 passed through the strait, which is the sole export route for Iran, Kuwait, Bahrain and Qatar and the primary route for Saudi Arabia and Iraq. New pipeline projects aimed at circumventing Hormuz will bring the percentage down in the coming years, but it will remain a major vein for oil market.

If there was a sustained disruption to flows through Hormuz, Singapore would be the hardest hit. Nearly 90% of the oil it consumes flows through the waterway. There would also be knock-on effects throughout the region, Mitchell notes, as much of the crude Singapore imports is refined and re-exported as fuel products.

Other major Asian consumers would also be left heavily exposed. Around 80% of India and South Korea’s oil flows through Hormuz and three-quarters of Japan’s consumption. China, which has been keenly aware of its energy vulnerabilities, would be relatively less affected, as just 22% of the oil it uses passes through the waterway, though it consumes more than 2m b/d of crude that passes through Hormuz.

Mitchell also shows the devastating economic effect for some countries that would come with the inevitable price spike. He bases his assumptions on a 50% increase in oil prices, to around $150 a barrel. In reality, even a much smaller disruption could see prices spike much higher, where they might remain for a prolonged period of time. In 2012, Iranian threats to disrupt the Strait of Hormuz were enough to put the oil market on edge.

Pakistan, Mitchell says, would burn through its foreign currency reserves in less than a year and a half if there were a sudden 50% oil price spike. India, Sri Lanka and Australia would last longer, but they would run through their reserves in four to five years. China, with its massive currency reserves, is best placed to withstand a run of higher oil prices. Despite this, any such sustained run on oil prices, even without a major disruption to physical supplies, would inflict major economic damage across the region.

Compounding the problem is the lack of international energy security governance in Asia. The West has developed a set of institutions, rules and strategic petroleum reserves that have made it much more resilient to a potential oil shock. The International Energy Agency (IEA), for instance, would coordinate action and provide predictability and transparency to the oil market.

The situation in Asia would likely be far more chaotic and uncoordinated. Japan and South Korea have joined the IEA and hold strategic reserves. China is building a strategic reserve of its own, though it won’t be completed until 2020. Beyond that there are few mechanisms in place to deal with an oil shock.

That is a problem for the region, but it is also a problem for the rest of the world. Mitchell sums up the risk: “In all likelihood, any major disruption of oil supplies would generate considerable uncertainty about how the various Asian governments would respond; and this uncertainty would, in turn, exacerbate the effect of such a disruption on global oil prices.”

And those higher oil prices, as Mitchell shows, would hurt Asia’s economies worse than most. It is in the region’s interest then to put plans in place that would help it deal effectively and predictably to an oil shock.

Ideally, Mitchell says, countries in the region would come together to replicate the oil security governance that exists in the West. But this is not going to happen anytime soon. There are no existing regional bodies that have comprehensive memberships to discuss the issue. Moreover, relations are worsening in the region, especially between China and its maritime neighbours.

Still the region’s governments can start to address specific problems bilaterally, multilaterally and nationally, says Mitchell. China and India, for instance, should work more closely with the IEA to prepare a coordinated response. It’s not clear, though, how likely that is. The IEA has long pressed China to cooperate with the West on energy issues, to little effect.

Asian consumers should also work more closely with their Middle Eastern suppliers to develop a plan on how they would allocate their available exports in the case of a supply disruption. Some exporting national oil companies such as Saudi Aramco with significant refining and storage facilities abroad may choose to prioritise shipments for those facilities, which would benefit Japan and South Korea. Others could simply cut exports to all its customers and maintain pre-crisis proportions.

Other urgent questions have to do with how China, Japan and South Korea would coordinate their emergency stock releases. China has said little about how it plans to use its strategic reserves. Japan and South Korea could choose to release stocks only domestically or to others in the region.

Over the long term, argues Ann Florini, an analyst at the Brooking’s Institute, a think tank, the G20 might be the most promising forum for Asia to develop a regional system of energy governance that could deal with oil security and other pressing environmental and trade issues. It could also provide a forum to coordinate policy with the West. Like Mitchell, Florini sees unsustainable energy policies as a major threat: “The inadequacies of incoherent energy governance are looming ever larger over Asia’s future.”

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