April 2, 2012

TSG IntelBrief: Obama Tightens Vice on Iranian Oil

• President Obama’s March 30 determination that Iran’s oil customers must choose between buying Iranian oil or doing business in the United States will result in a dramatic downturn in the Iranian economy.

• The timetable for sanctions on Iran’s oil exports is designed to allow Tehran’s oil customers  ? which include a number of U.S. allies ? several months to line up alternative supplies.

• The Administration has also used the timing of the implementation of the new law as a “last ditch” U.S. effort to coax Iran into a diplomatic solution on its nuclear program. If diplomacy fails in the next round of talks with Iran scheduled for April 13-14, discussion of U.S. and/or Israeli military options is likely to heat up dramatically.

At the end of March 2012, President Obama, acting under a provision National Defense Authorization Act for Fiscal Year 2012 passed in December 2011, determined the world oil market was sufficiently well supplied that countries around the world could significantly reduce their oil purchases from Iran. With the decision announced, Iran's oil customers must choose: significantly reduce oil purchases from Iran, find ways to pay for the oil other than dealing with the Central Bank of Iran, or have their banks prohibited from transacting business in the United States. Under this law, nations must make a choice by June 28, six months after the law's enactment in December 2011. The law was specifically structured to allow Iran's oil customers ? many of whom are allies of the United States ? enough time to line up alternative supplies.

Iran currently sells about 2.5 million barrels of oil to approximately 25 customers worldwide. This law, and the President's determination announced on March 30, are intended to compel these customers to reduce ? though not necessarily terminate ? their oil purchases from Iran. Even before the determination, several countries had been progressively reducing their purchases from Iran, and eleven countries were named as having done so. Of the eleven, ten were European Union (EU) countries, and the other was Japan. This qualifies the banks of these eleven countries for an "exemption," which means they can continue doing business with Iran's Central Bank while also continuing to do business with the United States as well. Several other customers of Iran, including South Korea and Turkey, are said to be negotiating with Washington to achieve a similar exemption by cutting their oil purchases from Iran by 10% - 20%.


Implications for Iran

The Obama decision's implications for Iran are potentially earth-shattering. Iran is dependent on oil revenues for more than 60% of its government budget. A sharp loss of oil revenues would render Tehran unable to fund its generous social welfare system, which includes direct payments of $40 per month to 66 million Iranians (a significant majority of its population of 75 million).

Oil industry observers predict that, through the application of the Obama decision and a related, but separate decision by the EU to end all Iranian oil purchases by July 1, Iran might lose up to 40% of its oil sales by volume. It then faces the prospect of losing even more as its remaining customers, most notably China and India, force Tehran to discount the price of its oil in order to keep these nations buying at current rates. At the predicted rate of revenue loss, Iran's hard currency reserve fund would soon be depleted and the government would be unable to fund its obligations. It is likely that massive new layoffs would result as government contracts ? a major source of income for the private sector ? are cut back.

Layoffs in the crucial oil industry would be inevitable, and this would likely lead to widespread strikes. The potential impact of such a scenario cannot be overstated; oil industry strikes helped bring down the Shah of Iran in 1979, a development not lost on the current regime.

As countries cut their purchases of Iranian oil, world oil prices will likely increase, but not dramatically, as Saudi Arabia ramps up production to meet the extra demand.

. Potential Havoc for Iran's Trading Community

Last Friday's decision by President Obama would not punish the act of buying oil from Iran, per se. Some countries, such as China and India, are already seeking to circumvent U.S. sanctions by engaging in barter trade for Iranian oil  and in paying for oil using local currency. In these cases, these countries would not have to make payments for the oil through Iran's Central Bank, an activity that would be sanctioned under the new law. However, these barter and local currency arrangements would deprive Iran of a vital source of hard currency, and therefore render Iran unable to stabilize its national currency, the rial. Since September 2011, the value of the rial has fallen more than 50%, from about 13,000 to the dollar to its current level of 20,000 to the dollar. That has dramatically driven up consumer prices and caused Iran's large trading community to suffer severe losses.

Not only are goods more expensive, some Iranian fear shortages and outright deprivation. Numerous observers report Iranians have been stockpiling staple goods, such as rice and cooking oil, in recent months.

. Strategic Effects

The Obama Administration and its partners are seeing the desired effects of their sanctions on the Iranian economy. However, the intent of the sanctions is not to cause economic deprivation for the Iranian people; rather, it is to persuade Iran to bargain seriously on the nuclear question. To date, the United States and its partners have not yet seen a discernible effect of the sanctions on that key question.

Iran has agreed to return to negotiations on April 13-14 with the six country negotiating group (U.S., Russia, China, Britain, France, and Germany). With President Obama stating that the "window for diplomacy is closing," the six will be looking for signs that Iran is ready to compromise in earnest, perhaps by agreeing to limit its enrichment of uranium. The fact that the Administration has decided to strictly enforce the new law has been useful to the Administration in the form of added pressure on Iran to compromise in the new talks.



Near-Term: • Although the effect of the sanctions on Iran's economy is potentially devastating, Iran fears military action more than the popular unrest that may arise due to economic conditions.

• At the April nuclear talks, Iran will try to present just enough flexibility to stave off serious contemplation of U.S. or Israeli military action against sits nuclear facilities.

. Long-Term: • It is unlikely that Iran will be sufficiently accommodating in its negotiating position to eliminate serious consideration of U.S. and/or Israeli military action. Open discussion of such an alternative could ultimately persuade Iran to make the concessions necessary to effectively defuse the issue.

• If the nuclear issue is unresolved, however, sanctions will remain at currently planned levels and that would produce the cascading consequences of a major downturn in the Iranian economy that would almost certainly lead to significant popular unrest.


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