Don’t expect an Iranian oil crisis

January 4, 2012, 10:17 PM UTC

Tensions are rising between the U.S. and Iran’s military leaders over the presence of Navy ships in the Strait of Hormuz, a key passageway for the country’s oil exports. Fears of imminent hostilities caused oil and gold to spike on Tuesday, but right now those fears look overblown. Beefed up sanctions by the U.S. targeting Iran’s central bank have tightened the noose around the government’s neck, but have hardly choked off the government’s air supply. As long as money keeps flowing into Iran, the country’s leaders will make sure to not cross the line.

This is the latest move in a complicated chess game between the U.S. and Iran. Each move made by the U.S. to undercut Iran is eventually countered somewhat successfully by the wily Iranian government. Hostile puffery by state apparatchiks and military officials from both sides tends to complicate matters and spook world oil markets, but at the end of the day, Iranian oil always somehow manages to flow out of the country and into the world market.

The latest drama revolves around beefed up sanctions imposed by the U.S. and its allies over Iran’s long-running pursuit of nuclear weapons. In the last two months, both the United Kingdom and the U.S. pushed though mandates barring any company that deals with Iran’s central bank from conducting any business in their respective nations. The European Union is expected to pass a similar measure this month and today has reportedly agreed to ban all Iranian oil imports.

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But while this would complicate Iran’s ability to sell oil, it will hardly kill it. There are enough banking institutions around the world with subsidiaries of subsidiaries that will facilitate the Iranian oil trade. Banks in Switzerland, India and China would be more than happy to help the Iranian central bank collect its cash. Iran’s central bank could also engage in barter transactions with international banks, similar to what it did during the Iran-Iraq war when the U.S. imposed similar sanctions on Iran’s banking system.

As for the potential European embargo, as long as oil demand from importing nations outside the embargo exceeds Iran’s 4 million barrel a day production capacity, there will always be a home for Iranian oil. Iran’s oil is relatively fungible, with both light and heavy grades, so it could run through most refineries with limited adjustments necessary to be processed into refined products, like gasoline and heating fuel. The limited amount of oil that Iran did export to the EU, mostly to Spain and Italy, will eventually be diverted to China or to another Asian country not participating in the embargo. While this change will have a destabilizing effect on the world oil market in the short run as the barrels get switched around, it will eventually work itself out.

Currency crash

But the bellicose comments out of the Iranian military have had an unintended consequence at home. The value of the Iranian rial has collapsed around 40% to the dollar in the last month to around 1800 rials to $1. The cutoff of the central bank, coupled with the possibility of war with the U.S., caused Iranians to rush out and buy dollars as a hedge to the rial. The rial lost 10% of its value over the weekend as lines formed at banks and in front of the homes of money changers that deal in dollars.

In response, Iran’s central bank yesterday instituted its own form of “quantitative easing,” flooding the market with U.S. dollars from its reserves. The rial appreciated around 20% against the dollar but demand still remains high.

This shock to Iran’s internal economy should be a wake up call to the mullahs in Tehran. It is just one of possible negative side effects of ramping up the rhetoric with the U.S. To be clear, Iran could successfully close the Strait of Hormuz if it really wanted to. It doesn’t even need its Navy to do it. It could simply sink a few barges in the narrowest parts of the waterway and lay a few mines. That would make the strait impassible to the dozens of supertankers that go in and out of the Persian Gulf everyday.

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But the question is: can Iran afford it? Clearly not. Shutting the straits down in such a crude fashion would not only block supertankers from Saudi Arabia, Kuwait and Iraq from getting through the strait, but would also block its own super tankers from getting through as well. With the oil trade making up around 60% of Iran’s economy, that would be disastrous. Sure, oil could spike as high as $200 a barrel, but if Iran can’t get its oil out to market, it won’t be able to profit off the chaos it created.

Shutting down the Persian Gulf would be equivalent to Iran slicing its own wrists. Vital deliveries of food, fuel and other goods from abroad would have no way of reaching the country. The internal chaos created could see a mass revolt in the country where the majority of the population cares more about their quality of life than the Mullah’s chess game with Washington.

Likewise, the U.S. would loathe having a conflict with Iran given how important it is to the international oil markets. While Iranian oil doesn’t run through U.S. refineries, it does run through those in Asia and Southern Europe. Taking that supply off the market will force those countries that depend on Iranian oil to look to other countries that do export oil to the U.S., therefore decreasing worldwide supply and causing prices to spike. Saudi Arabia and Russia do not have enough spare capacity to replace all the barrels lost if Iran were to go offline, so there would certainly be shortages at the gas pump. The result could crush the nascent economic recovery in the U.S. and push all of Europe into a deep recession.

The U.S. and Iran may hate each other, but their fates are inextricably linked. Neither side is itching for war given all the negative side effects that could come to both of their economies. Oil prices should eventually calm as it becomes clear that this battle between East and West is more about dollars than ideology.