12 January 2012 at 10:42 GMT
Iran has been threatening to close the Strait of Hormuz if Europe and the United States block Iran’s oil imports. This has already caused the price of oil to increase but less than expected because of the credit worries in Europe. Because of the potential embargo, Iran has threatened to run more war games towards the end of January to reassert its strength and its ability to enforce a closure of the Strait should an embargo of Iran oil occur.
Approximately 20 to 25 percent of the world’s oil goes through the Strait of Hormuz in the Persian Gulf, which is the equivalent of about 17mbopd. The passage is crucially important to the interrelated energy markets and specifically to Asian countries with 85 percentof the Persian Gulf supply going to those countries. Iran has repeatedly threatened to close the Strait which would deeply affect global energy markets. This would impact every country in the world including Iran, which is also deeply dependent on trade through the gulf because of the need for lighter, refined fuels. Whether or not the threats are veiled, is partly irrelevant as investors are already weary of the credit problems in Europe and a spike in oil prices, even in the short term, could further damage the economy and send equity prices tumbling.
Chart 1.
As we saw in December 2010 until the end of Q1 2011, the Arab Spring, created a great rise in oil prices, see Chart 2. Libya’s oil production prior to the revolution was approximately 2 percent of global production. During the Libyan revolution we saw how the threat of losing this production demonstrated how fragile the global supply and demand for oil is.
Effect of Oil embargo
Since Iran produces approximately 4 percent of global oil production, we can simply imagine the repercussions of an Iranian oil embargo on the energy markets. Although most of the embargoed supply will be re-routed to the Asian customers, all of these countries (excl. China and Japan, see Table 1) have already agreed to the embargo.
Furthermore the exclusion of Iranian oil would affect some of the most vulnerable European countries such as Greece and Spain. And although the oil can always be re-routed as it is a global commodity, the logistical implications of this are massive which could create additional tensions in energy markets.
Effect of a blockade of the Strait of Hormuz
Iran has threatened to shut off the Strait of Hormuz in retaliation for an embargo of Iranian oil. While this is most likely only sabre rattling, a full blockade by the Iranian navy of the Strait would cause major damages to a very sensitive global economy. Although it seems simple for the United States to send its fifth fleet into the gulf, it is quite far from this as the US is at a major tactical disadvantage in the gulf due to the region (which the Pentagon is fully aware of) i.e. Iran’s faster more flexible navy, and Iran’s onshore missile batteries.
Simply imagining a 20 percent decline in oil supply, even for a short period, would send markets over the abyss. The only solution that could replace this output would be from the global strategic petroleum reserves, currently at a reserve of 4.1 billion barrels, 1.4 of those under government control. By doing the maths we can calculate that the strategic reserves would last approximately 80 days at the current rate. Additionally, although many pipelines exist that may alleviate supply restrictions from the Gulf, these have either for political or operational reasons been mothballed, and the few pipelines that are currently operational, either do not have the capacity or most importantly cannot replace the large amount of oil shipping coming out of the Strait (Chart 1).
So who will blink first? Who knows, but one thing is certain the next few weeks should make for volatile energy markets should things escalate. In part 2, we will examine exactly who is at risk should diplomatic talks breakdown and how equity investors and traders could potentially profit from this political risk.