The unexpected logic of the EU’s ban on Iranian oil

The European Union’s recent agreement in principle to gradually ban Iranian crude oil imports has brought to a head a long-running dispute between Europe’s economic and foreign ministries. Economic ministries feared politicizing oil because any disruption could hurt fragile economies and send prices soaring. Foreign ministries, for their part, were eager to turn the screws on Tehran with an oil embargo that would raise the costs of the country’s alleged pursuit of nuclear weapons. This gap is narrowing fast — but not only because of the urgency of increased diplomatic pressure.

EU ministers will discuss the embargo on January 23 after two weeks of saber-rattling in the Persian Gulf. Iran’s leaders have directly linked restrictions on crude exports to the regime’s willingness to shut the Strait of Hormuz. Last month, Mohammad-Reza Rahimi, Iran’s first vice president, warned that "If they impose sanctions on Iran’s oil exports, then even one drop of oil cannot flow from the Strait of Hormuz." His comments came days before President Barack Obama approved new U.S. sanctions against the Central Bank of Iran, which manages the country’s oil transactions.

The stakes are high for Tehran. The regime depends on oil revenue for 50 percent of its budget. Last year that sum amounted to $73 billion. Iran exports 450,000 barrels per day (b/d) to Europe, which amounts to 20 percent of the country’s total crude exports. Some observers worry that an EU embargo could backfire and send oil prices sky-high. But these fears may be exaggerated.

Any shock to the system will be cushioned by several factors. Libya and Iraq are set to increase exports this year; these additional barrels could replace Iran’s share of the European market. New projections from the International Energy Agency (IEA) are also encouraging. In their last public report, the IEA offered a "more comfortable market outlook than looked likely six months ago." According to the report, global demand for crude from the Organization of Petroleum Exporting Countries (OPEC) will likely shrink this year by 300,000 b/d, thus providing more slack in a tight market.

The newfound EU agreement comes at a time when Libyan and Iraqi production is set to increase significantly. Both countries will thus have a chance to enter — or in Libya’s case, re-enter — the European market and offset any supply disruption. Seasonal oil demand changes and projections for global consumption in 2012 also suggest price hikes can be avoided if Iranian crude is sold elsewhere. The regime would likely be forced to do so at a discount and lose precious revenue at a time when the Iranian economy is already under tremendous stress.

Libyan exports recovered faster than expected after being shut down by civil war. Libya now produces 1 million b/d with exports hovering around 500,000 b/d. Representatives of the national oil company and their international partners are convinced the country will return to pre-war production levels by the middle of 2012. Within six months, Libya could produce 1.7 million b/d with exports nearly tripling to 1.3 million b/d. Especially encouraging is recent news that Es-Sidr, Libya’s largest oil export terminal, restarted crude loadings this month. In January 2011, Es-Sidr loaded nearly 450,000 b/d — about as much as Iran stands to lose if the EU ban is adopted. Much of that oil went to Europe before the civil war, and so the Libyans are well positioned to cushion the market in case of embargo.

Iraq is also on track to increase crude exports in the first quarter of 2012. Right now the maximum export capacity from southern Iraq — where the government’s authority over oilfields and revenue is not in question — stands at 1.8 million b/d. New pipelines will soon come online that connect to single point moorings in the Gulf where tankers can load crude. Each mooring can handle up to 900,000 b/d and the first will become operational in the next three months. According to estimates made last month by Hussain al-Shahristani, Iraq’s deputy prime minister for energy affairs, officials believe southern fields alone will export 225,000 b/d more in 2012. Northern fields will export another 175,000 b/d.

Combined, Iraq and Libya could replace Iran’s lost crude destined for Europe. It may not be appropriate to label Iranian crude "lost," however, as Iran may still sell its 450,000 b/d elsewhere — but at a discount. As Europe distances itself from Iran and the number of possible buyers shrinks, the remaining customers will enjoy more leverage during contract negotiations. China, Iran’s biggest customer, recently signaled that it’s willing to play hardball: the country’s largest oil company — Sinopec — cut January purchases of Iranian crude by half after pricing negotiations stalled. New terms may not be finalized until March. In the meantime, Chinese traders are buying pricier alternatives instead of Iranian crude. Others may twist Iran’s arm the same way.

Chances are the regime will not curb production even if it temporarily lacks customers. Doing so is risky because the country’s oil infrastructure is not in prime condition; after decades of sanctions, shutting in production could result in unforeseen technical failures, and future problems when trying to return to maximum output. Continued production means Iran will be forced to store oil while waiting for buyers to satisfy current contracts. With 450,000 barrels accumulating daily, Iran could find itself with millions of barrels of oil — stored at home and off-shore — waiting for the right customer months later. Opportunistic traders could eventually buy up dozens of these cargoes at a steep discount.

Any ban will grant Europe a few months to wind down business with Iran and gradually shift to other producers. That shift, should it commence, would occur during the second quarter of this year, the traditional period of weak worldwide demand. It seems very likely that Arab producers like Libya and Iraq will gain or regain their market share if given the chance. And, if the IEA’s predictions are correct, the shrinking demand for OPEC crude may make the European transition considerably smoother.

Matthew M. Reed is a Middle East specialist at Foreign Reports, Inc., a consulting firm in Washington, DC. More of his commentary can be found at Al Ajnabee, where he writes about the Middle East and U.S. foreign policy. The views expressed here are solely his.