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Talk of conflict in Hormuz is a red herring for oil market

Talk of conflict in the Strait of Hormuz misses the real threat to the global oil market

Iran's threat to close the narrow body of water that connects the Mideast Gulf with the global oil market is neither credible, nor the worst possible outcome of rising tensions between the country and its Western enemies.

The Strait of Hormuz is certainly a critical “artery of global trade”, as UK defence minister Philip Hammond said in London today. About a fifth of the world’s oil flows from exporters in the Middle East through the Strait. Shutting it down would trigger an immediate oil-price spike. Depending on the duration of the shut-in, $150 a barrel oil would be just the starting point. (Brent crude futures have risen by 4.6% since the start of the year, to $112/b.)

That’s why any attempt to shut down the waterway would be met with instant and near unanimous condemnation by the UN. Iran could find the means to shut the Strait: by planting mines or attacking tankers – both tactics the country attempted in the 1980s, until a show of force by the US Navy calmed the waters.

But, treating any aggression against traffic through the Strait as an act of war, the US and UK would annihilate Iran’s nearby military installations, claim analysts – with the support of other Mideast powers.

Meanwhile, Iran’s economy depends on the traffic of crude, shipping about 2 million barrels a day (b/d) of its own oil through the Strait. And the country’s allies in the UN, especially China, also rely on exports through the channel. It would be a desperate and short-lived act of retaliation. And it is extremely unlikely.

The military figures in Iran who have threatened to shut the Strait have been speaking above their pay-grade, said one analyst of the country.

A dangerous place for global oil

But that hasn’t stopped mainstream media from talking up the problem. The Strait is an easy scare story. But don’t be distracted by the Hormuz sideshow. Iran, the US and the EU are marching towards a far more dangerous place for the global oil market.

Momentum in the EU and US is now squarely behind new sanctions on Iran’s oil and its central bank. The timing of both measures isn’t yet clear. The EU could formalise its embargo by the end of the month, but it may not take effect until existing supply contracts have expired – giving Greece, Italy and Spain, the three biggest importers of Iranian oil in the EU, time to find alternatives (see Figure 1).

The US sanctions on the Iranian Central Bank (ICB) are, in theory, more severe: any company with exposure to the US market, including Indian and Chinese firms, would be punished if it paid money to the ICB, which takes payment for Iranian oil exports. President Barack Obama signed the bill into law last month. But he retains a waiver, which would exempt from punishment any companies that have visibly reduced their trade with Iran. Japan, a buyer of Iranian oil, has already begun lobbying the White House for such a waiver.

Ratcheting up the rhetoric

But Obama will be under pressure to make the sanctions hurt. Squeezing Iran will make for good politics in the West. Presidential election season in the US will see the contestants ratchet up the rhetoric. The president who felled Osama Bin Laden won’t want to look soft on Iran.

If the sanctions are to work they’ll have to bite, which is when the situation for the oil market will become serious. Iran’s economy is already sagging. A crash in the country’s currency, the rial, in recent weeks, triggered by the prospect of tighter financial measures, will hurt Iranian consumers as prices for imports soar and inflation rises.

Wider economic problems that cause unrest, as much as any sanctions, would hit Iranian oil exports, which account for about 3% of global consumption. Any longer-term crisis in the Iranian economy would shut in production, whether the country’s government had by then backed down over the nuclear issue or not.

It was a general strike in 1978 that cut oil production from about 6 million b/d to 1.5 million b/d – toppling the Shah, ushering in the Islamic Revolution, and bringing a severe oil shock to the world economy.

Who controls Iraq?

Likelier than conflict in the Strait or the collapse of the Iranian economy is that Iran will respond to what it takes to be new aggression by proxy retaliation elsewhere in the Middle East.

“Who controls Iraq?” asked Iran’s deputy oil minister Alireza Zeighami in an interview with Petroleum Economist last month. “We do”. More violence in Iraq, encouraged by Iran’s Shia proxy groups in the country, could widen the conflict – and the implications for the world’s oil supply.

The politics in Iraq are already splintering again in the wake of the US troop withdrawal. The government of Nuri Al-Maliki, which is backed by Iran, is disintegrating into Shia-versus-Sunni factionalism. Tariq al-Hashemi, Iraq’s vice-president and the country’s most senior Sunni politician, fled to Kurdistan last month after Maliki’s government issued a warrant for his arrest, accusing him of heading up death squads. A spate of lethal bombings, the most recent in Sadr City, a Baghdad suburb that is the base of the Iran-backed Mahdi Army, has heightened tensions still further.

Allowing Iraq, which is increasingly under Iranian sway, to fall apart in violence – or exacerbating the situation to the point of a new civil war – is a likelier and easier way for Iran to hit back at the West. Beyond the political chaos, this would also threaten existing Iraqi oil production, which now stands at 2.7 million b/d, let alone the country’s plans to increase output to around 3.3 million b/d this year.

The International Energy Agency stands by its forecast that Iraq’s output will grow to more than 4.3 million b/d by 2016 – but is also growing cautious, saying potential risks to such an increase will come from “the withdrawal of US troops and fears of escalating instability as insurgency bombing increases”.

So a Western strategy to hit Iran’s oil industry could also hurt Iraq’s. Diminishing Iran’s 2.2 million b/d oil-export capacity would already strain Opec’s spare capacity, forcing Saudi Arabia to max out production at more than 12 million b/d. If the unintended consequence of the measures against Iran were more conflict in Iraq and a loss of its production, or scaling back of its forecast output growth, the oil market would come under severe strain.

Shutting the Strait of Hormuz would spike the oil market and hurt the global economy. But renewed chaos in Iraq would cause even more lasting damage.

Figure 1 - Iranian oil exports by destination
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