GEO ExPro

Oil: A Political Tool

Oil is the world’s most powerful political tool at the moment.
This article appeared in Vol. 9, No. 1 - 2012

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The busy souk in Esfahan, Iran. Image: Ingvild Carstens While softer supply/demand balances point to weaker oil prices in the first half of 2012, global geopolitical risk outweighs the bearish fundamental signal. OPEC’s new 30 MMbopd production target will do little to cut down on oversupply in the market as we expect the call on OPEC will be below this target, at 29.35 MMbop for the first six months. Nevertheless, the recent sabre-rattling between the West and Iran has pushed up the political risk premium by US$6–8/barrel since mid-December. We expect oil prices to average US$107/barrel in Q1 2012, but the risk is on the upside as the political risk premium may push prices higher.

With President Obama signing a sanction bill on the last day of 2011, making it more difficult to sell Iranian oil, and most EU countries now supporting an embargo on Iranian oil, the pressure on Iran has clearly been building lately. In response to this, Iran has threatened to close the Strait of Hormuz, which would have an immense effect on the global oil market. The elevated rhetoric together with Iranian threats and naval activity in the Persian Gulf have increased the risk of confrontation.

We expect the political climate between the West and Iran to deteriorate in the weeks to come as the verbal war will continue and pressure will be building up to the next milestone – the EU meeting on 30 January. With the Arab Spring and production stoppages in Libya fresh in mind, the risk premium – and thus oil prices – may continue to rise before the EU meeting, as the oil market is increasingly worried that the political tensions between the West and Iran will escalate to a military conflict that may harm oil production and transportation in the area.

Neither Iran nor the US wants a military conflict in the region or to push the ongoing conflict too far. But the pressure is high on both sides. It is election year in the US and Obama has been criticised for being too soft on Iran. Tehran’s main goal is to scare the US and its allies away from implementing new and tougher sanctions which could break the country financially.

Closing the Strait?

However, we do not expect that Iran will push forward the closure of the Strait of Hormuz or a military conflict as this would block the country’s ability to export oil and hurt the economy badly. Oil exports provide half of the Iranian government revenues and account for around 80% of total exports (EIA).

In addition, an Iranian closure of the Strait of Hormuz for an indefinite period of time will have severe repercussions on the country’s most important trading partners, China and Russia. Thus it is not likely that Iran wants to use this tactic as it will isolate the country further both militarily and economically. China is the largest importer of Iranian oil with 543 Mbopd, followed by Japan (341 Mbopd), India (328 Mbopd) and South Korea (244 Mbopd) (EIA). The increasing political tension in the area and the US sanctions have clearly started to hurt Iran’s trade relations, as reported by the Financial Times recently, with Japan and South Korea trying to reduce their dependence on Iranian oil by seeking new suppliers. China and India have not signalled that they will follow these examples and bow to the pressure from the US to stop trading with Iran. These countries can actually benefit from the situation as they are now in a position to push for lower prices for Iranian oil.

Disruptions to the flow of oil through the Strait of Hormuz would threaten regional and global economic growth. Higher oil prices can push large economies over the edge and into a double-dip recession. A sharp fall in the world economy will have a severe impact on global demand for oil and may trigger a rapid fall in oil prices.

Saudi Arabia is the only oil exporter able to increase production substantially if global oil supplies are disrupted. OPEC’s total effective spare capacity buffer is 3.95 MMbopd today, with Saudi Arabia accounting for almost 60%, which is not enough to cover the loss of Iranian exports, totalling 2.5 MMbopd. The growing appetite for the Kingdom’s oil from EU countries, in case they go ahead with an embargo, and from Asian countries to reduce their dependence on Iran, is clearly cutting sharply into Saudi Arabia’s spare capacity buffer. The country’s ability to work as the producer of last resort will be weakened, making the global oil market more exposed to supply-side disruptions outside Iran. The political risk is also high in countries like Iraq, Nigeria, Kazakhstan, Sudan, Syria and Yemen.

Military Confrontation?

What may happen if the West attacks Iran? The response is expected to be severe and may lead to serious disruptions of oil supplies coming from the region. A military confrontation will increase the risk of damage to oil installations and tankers in the area, which could halt oil production and transportation for an extended period of time. The entire area will be affected by a military attack on Iran and, according to a Saudi journalist talking to the newspaper Al Jazeera, that “will make damages beyond calculations”. Iran’s own predictions of an oil price around US$200/barrel may then become a reality.

In addition, frustration with the current leadership in Iran is increasing, not only from the Arab countries but also internally. Isolating the country further economically and politically by souring the relationship to vital trading partners such as China and Russia and its Arab neighbours may put the current leadership under further strain. The Iranian leadership is trying to prevent a political uprising similar to those seen in Libya, Egypt and Tunisia last year.

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