March 28, 2012

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TSG IntelBrief: Iran Faces Oil Embargo With Few Strategic Options: Near-Term Defiance Shifts to Long-Term Compromise

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As of late March 2012, the European Union (EU) was set to completely end its purchases of Iranian oil by July 1, 2012.  This decision, reached by the EU in January 2012, resulted from a diplomatic rift driven by Iran's overreaction to British sanctions announced in November 2011. That month, a group of militants — apparently with Tehran's backing — stormed British diplomatic compounds in the Iranian capital, which prompted an exodus of EU diplomatic personnel and across-the-board EU support for a French proposal to end purchases of Iranian oil.

Iran has reacted harshly to the EU embargo decision, but many of its threats have been hollow. Iran first threatened to close the strategically vital Strait of Hormuz, through which 40% of the world's traded oil flows, but later dropped that threat. Iran subsequently threatened to cut off sales of oil to EU countries prior to the embargo taking effect, but then withdrew that threat as well.

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Low Probability of Near-Term Compromise

The economic pressure such an embargo will place on Iran might cause the country's leaders to reconsider their consistently intractable position on a nuclear compromise, but only over the long-term; Tehran is unlikely to give ground on the issue in the near future. It is important to recall that Iran's population stoically suffered through the substantial deprivation of the bloody, eight-year war with Iraq, and it is unlikely to immediately pressure the leadership in Tehran to bargain away the nation's long-sought nuclear options.

Saudi Arabia and other Persian Gulf oil exporters are wary of Iranian intentions and will seek to avoid exacerbating the situation with openly antagonizing words or actions. However, these countries are closely aligned on a strategic level with the United States and are thus far committed to helping put pressure on Iran. They will, for example, eagerly offer additional oil sales to EU members and other countries that are cutting their oil purchases from Iran. In addition to the potential political capital they might earn from such a move, the extra sales will clearly have the attractive benefit of helping Gulf exporters earn far more revenue than anticipated in 2012 and beyond.

As the embargo takes effect this summer, Iran will almost certainly threaten to lash out, possibly by renewing its threats to the Strait. However, its ultimate reaction is likely to be more measured, taking the form of stepped up efforts to find new customers. Iran's oil exports account for about 60% of government revenue and, unless it can make up at least some of the shortfall by finding new buyers for its oil, the embargo is likely to have a severe impact on Iran's economy.

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Economic Impact Exacerbated by Indian and Chinese Exploitation

To put the embargo into context, the EU accounts for about 22% of Iran's oil exports. Several other major oil customers, including Japan, have already promised to cut oil purchases from Tehran by at least 20%. South Korea, another close U.S. ally, is very likely to follow suit. Although there are no expectations that non-EU buyers will completely end purchases of Iranian oil, the loss of sales to these major buyers could reduce the volume of Iran's oil export — currently 2.5 million barrels of crude per day — by as much as 40%.

For now, China and India will continue to buy Iranian oil at prior levels, but they are also leveraging Iran's predicament for their own economic advantage, including persuading Iran to accept foreign currency (for example, rupees from India) as partial payment. Politically, India shares a number of common interests with Iran in Afghanistan and in creating stability in South Asian, but U.S. pressure will likely persuade India to gradually reduce its oil purchases nonetheless. Similarly, China is expected to gradually cut its purchases from Iran as it lines up new supplies from Saudi Arabia and/or Iraq. To justify their actions, both countries — along with any potential new customers — will possibly cite a late 2011 U.S. law that levies sanctions on foreign banks that pay Iran for oil through its Central Bank, a provision that has greatly complicated efforts to pay Tehran for oil in hard currency.

As the loss of oil sales begins to slice into Iran's economy, the nation's currency will plummet even further than it already has. Since December 2011, the value of Iran's currency — the rial — has fallen by nearly 50%.  As it is increasingly forced to accept payment for oil in the form of barter arrangements or non-convertible currencies, Tehran's will face a corresponding erosion in its ability to stabilize their currency.

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Forecast:

Near-term Forecast:

• U.S. and international officials are closely watching for signs the EU embargo will cause Iran to compromise on it nuclear program when a new round of talks are convened in mid-April. Iran is unlikely to make major concessions at these talks in the belief that it can ride out the sanctions, secure new customers, and somehow inflate world oil prices. Unless Iran is willing to negotiate on its nuclear program, however, the international pressure on Iran's economy will only tighten further.

Long-term forecast:

• Iran might seek a nuclear compromise as a means of reviving its economy and relieving domestic pressure. The loss of oil sales will render the country increasingly unable to sustain its social welfare and defense spending. This is likely to spark popular unrest that has been largely formant since the 2009 uprising. The regime will ultimately compromise on its nuclear program if it believes such a move is necessary to maintain its grip on power. As Iran's economy deteriorates, it will be unlikely to find sufficient funding to maintain its current oil production. As a result, it will gradually lose its position as a major oil producer and exporter, and its regional prestige and influence will decline in concert.

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