Europeans fear Iran oil embargo will wreck economy

With a proposed embargo on Iranian oil, the European Union and the US could suffer from rising oil prices while Iran simply finds new buyers.

The European Union is poised to ban Iranian oil imports, even as critics warn the move could bring deep economic pain to the continent while doing little to change the course of the Iranian nuclear program.

Iran is playing a game of political chicken with the EU and US. Iran loses if it can't sell its oil.  But its leaders are calculating that the tight oil market and a weak global economy will prevent the West from being able to persuade others to join their embargo, allowing Iran to simply find new customers. The outcome is completely uncertain, but it will have a substantial impact on the global economic recovery.

On Jan. 23, The EU's foreign ministers are expected to officially approve an embargo on Iranian oil after agreeing in principle to the move earlier this month. They'll likely agree to enforce the import ban from July, in order to give countries time to make alternate import arrangements – a middle ground between the three months delay that some want and the 12 months others prefer. The more Iranian oil each EU member relies on, the less enthusiastic they are about quick implementation, say EU and Spanish officials and the International Energy Agency, which advises OECD countries on energy issues. 

EU leaders have gradually warmed to the idea of targeting Iran’s oil industry – which contributes about half of the Islamic Republic’s budget – in hopes of compelling its leaders to forgo uranium enrichment that could eventually be used to develop nuclear weapons. So far, Iranian leaders have only grown more defiant in response to more pressure. 

The oil embargo is just one facet of a complex game and passionate tit-for-tat threats from Iran and the US, Europe, and Israel that will have a dramatic impact on global supply lines. Iran recently threatened to close the Strait of Hormuz, a critical waterway for oil shipments from the Persian Gulf. Blocking the Strait, through which about 20 percent of the world's oil passes, would trigger a supply crisis. The US has warned such a move would prompt a military response. 

The oil industry sees little chance of war, but it does fear further escalation of the protracted diplomatic standoff between Iran and the West, which could prolong economic uncertainty, cause oil prices to rise, and lead to further instability in the Middle East and oil markets. 

The economic costs stand to be significant at a time when Europe can least afford it – so why is Europe doing this? “The end game in this policy course is not to minimize the price of oil, but to prod Iran into a different policy,” says Harry Tchilinguirian, the head oil market analyst of France's BNP Paribas, one of the world’s biggest banks.

It will 'backfire'

“I don’t know why Europe is going along with this. Europeans have been more balanced than the US, but somehow they have become more emotional. [Joining the embargo] will backfire,” says Iraqi Manouchehr Takin, a senior oil markets analyst with the London-based Center for Global Energy Studies who spent almost a decade in the secretariat of the Organization of the Petroleum Exporting Countries (OPEC). The embargo could end up hurting the EU more than Iran.

“Those who will suffer are refiners in Europe, especially those in countries in financial problems like Italy, Spain, and Greece,” says Dr. Takin. The three buy three quarters of the Iranian crude purchased by the EU and are the ones pushing for a delayed embargo so that they have time to find alternative sources for affordable oil.

The EU was Iran’s biggest client, buying nearly a quarter of its exports between January and October 2011, according to the figures released Wednesday by the IEA. China bought 22 percent and India 12 percent. [Editor's note: This sentence was edited to correctly reflect the date of the IEA figures.]

But oil is fungible, meaning it can be moved around easily and on short notice. In fact, the US and European pressure has already caused changes in oil import-export patterns in the last two quarters. OECD countries have been “aggressively seeking alternative supplies, especially [from] Saudi Arabia,” according to the IEA, and while they still buy more than half of Iran’s oil, Iranian oil shipments are increasingly heading toward non-OECD Asian buyers.

However, OPEC would be simply unable to offset Iranian crude supplies for a long time. Even with Libya’s production increasing and slowing growth in demand for oil as a result of the economic crisis, the realistic global spare oil production capacity is less than 2.9 million barrels per day – 40 percent less than in 2010,  a dangerously small cushion going forward as emerging economies continue to expand and the developed world returns to growth. 

Embargo support losing steam

Outside the EU, support for the embargo is waning. Japan backtracked on its early support, with Prime Minister Yoshihiko Noda overruling the finance minister, who initially said Japan would cut imports.

“We do understand that we need to maintain sanctions, but they must be carried out effectively,” said Foreign Minister Koichiro Gemba. “What's going to happen if oil prices surge is that sanctions will not be effective,” Gemba said. The higher oil prices get, the more money Iran has, while having “an adverse effect not only on the Japanese economy but also the entire global economy.”

India and China – which import 12 percent and 22 percent of Iranian oil respectively – have also balked at an embargo for unrelated contractual differences.

If the EU decision is not backed by other major importers of Iranian oil – Japan, China, India, and South Korea – it will cause only a temporary disturbance while Iran finds new buyers for the oil that previously went to Europe, says Mr. Tchilinguirian.

“If you add other major importers than the opportunity for alternative oil grows scarce, at which point available supply is not sufficient,” he said. 

Furthermore, a partial embargo also helps other US antagonists with oil supplies, such as Russia and Venezuela. Global prices have already climbed more than $10 a barrel since the EU first signaled its intentions late last year and the IEA and analysts concur that prices will continue climbing  because of the Iran standoff.

“Iran might lose part of its customers for a few months until it adjusts, but higher prices will compensate,” Dr. Takin said.

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