Are sanctions to blame for rising oil prices?

Last month at Foreign Policy I argued that the EU ban of Iranian crude was logical. I focused on how European markets and the Iranian oil industry would be affected by an embargo. My conclusion was optimistic. “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,” I wrote on January 10. “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.”

But since the EU embargo was made official on January 23, the price of crude oil has risen dramatically, leading some to ask me whether the EU’s meddling is to blame. Brent hovers around $125 at the moment. Meanwhile, WTI, the American benchmark, is priced closer to $105. Dishonest reports from Iran have injected more anxiety into the market, as semi-official media sources claim that Iran is cutting off European refiners before the EU ban comes into effect July 1. Here in the U.S., presidential hopefuls blame President Obama for rising costs.

Market analysts are making two very different arguments at the moment: one holds that speculators deserve blame; the other argues that sanctions are most responsible for the price hike.

McClatchy’s Kevin Hall pointed the finger at speculators on February 21.  “While tension over Iran has ratcheted up over the last few months, the price of oil and gasoline has leaped far beyond conventional supply and demand variables. Financial speculators are piling into the market, torquing the Iranian fear factor into ever-higher prices,” he wrote last week. “What’s indisputable,” he adds, “is that oil and gasoline are not in short supply, and that demand remains weak. That was crystal clear in the latest weekly energy market update by the U.S. Energy Information Administration published last week for the week ending Feb. 10.” Hall also cites a Wall Street Journal interview with Didier Houssin, director for energy markets and security for the International Energy Agency. Houssin told the Journal that “there are alternative supplies that can make up for any loss of Iranian exports.”

Reuters market analyst John Kemp disagrees. Yesterday he argued that sanctions have “backfired.” Kemp says, “Two things have gone wrong. First, sanctions are interacting with other supply disruptions (in South Sudan, Yemen, Syria) to reduce supplies and exhaust the cushion of spare capacity Saudi Arabia holds. Second, the thicket of sanctions on Iran imposed by the European Union and United States is now so complex it is becoming hard to conduct trade that is supposed to be permitted.” He claims that, although sanctions are flexible, and exceptions may soon be allowed, “many emerging markets have not taken up the extra Iranian barrels no longer being delivered to Europe, and most are scrambling to cut their reliance on Iranian imports.”

I’m inclined to agree more with Hall. Kemp, for his part, concedes that “Sanctions cannot be blamed for the entire increase in oil prices.”  While he argues that countries are “scrambling to cut their reliance” on Iranian crude, readers might be surprised to learn that China, India and Japan plan to cut 2012 purchases by only 10 percent each, which still leaves all three countries importing plenty of Iranian crude. South Korea is considering similar cuts. Iran might lose more business if SWIFT, the world’s premiere banking cooperative, cuts off Iranian financial institutions that handle oil transactions.

Kemp offers an important data point also: “The steeply backwardated structured of futures markets suggests there are concerns about the availability of alternative supplies, despite Saudi offers of extra barrels. Hedge funds and other money managers have boosted long exposure to crude futures and options by more than 80 million barrels since the start of November and by more than 65 million since the start of the year.”

Anxiety is pushing hedge funds to question the availability of alternative sources, as Kemp says. But the EU banned only 450,000 barrels of daily imports. Sanctions might only force several other countries to cut imports from Iran by 10-20 percent. Even if SWIFT halted Iranian transactions, chances are the Iranians would pursue alternate arrangements, like they’re doing now with India. This leaves Iranian exports cut down but not out of the market entirely. To be clear: Making up for a million lost Iranian barrels–and disruptions in Syria, Yemen, and the Sudans–is possible in today’s market according to many observers. And so I find it hard to believe that sanctions are most responsible for rising prices. Traders must instead be accounting for far greater losses if Iran’s oil is replaceable.

If so, the prospect of war looms largest. Worries abound and are bolstered by weeks of feverish reporting. Each day new headlines and quotes attributed to high-level sources (many anonymous) speculate about an Israeli strike. Congressional hearings raise the question. And, according to a controversial report in the Washington Post, Defense Secretary Panetta is convinced the Israelis will make their decision in the coming months, and possibly attack in April, May or June. Should war erupt, millions of barrels that normally pass through the Strait of Hormuz might temporarily disappear. Naturally, this possibility has the industry on edge and hedge funds betting on the worst possible outcome. According to the Israeli newspaper Maariv (as quoted by AFP), Israeli Prime Minister Benjamin Netanyahu realized a very public discussion about military strikes was counterproductive earlier this month. “Stop blabbing, already,” the PM supposedly told officials. “This chit-chat causes huge damage, puts Israel on the front line, and damages sanctions,” he warned.

Right now speculation about war is undermining the effects of sanctions. With oil selling for well over $100 per barrel, cuts in Iranian crude purchases don’t harm the regime’s revenue stream like they would without the “fear premium.”

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