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Iran's Potential Impact on the Global Oil Market

Over the past few weeks, speculation has increased regarding the likelihood of an Israeli attack on Iranian nuclear facilities.  This has arisen because of Iranian cries of an Israeli-led assassination of one of Iran’s top nuclear scientists and Israel’s belief that Iran is targeting Israel’s diplomats in Thailand and other Asian countries.  At the same time, the U.S. and U.N. have called on Israel to refrain from attacking Iran because they believe that Iran could then target American civilians and assets in the Middle East and Afghanistan.  Preemptively, the U.S. has moved two aircraft carriers and a nuclear submarine into the Arabian Sea.  Could Israel see an attack on Iran as the only option to preserve the long-term survival of its nation-state?  Perhaps.  Even more likely than a military strike, an embargo on Iranian oil exports could occur.  Because of these possibilities it is important to ponder the consequences of these actions on the global economy.  Iran, a member of the Organization of the Petroleum Exporting Countries (OPEC), was the third-largest exporter of crude oil globally after Saudi Arabia and Russia in 2010.[i] [ii]

Because of the importance of Iran in the global oil markets any increase in the probability of a military strike on Iran could have negative consequences for the global economy.  Already, the price of West Texas Intermediate Crude Oil has risen above $106/barrel, a nine-month high, and the price of Brent Crude Oil –which is used to price two-thirds of the world’s internationally traded crude oil supplies –has crept above $120/barrel.[iii]  According to Deutsche Bank:

“A $10 increase in oil prices translates into roughly a 25 cent increase in retail gasoline prices.  Every one penny increase in gasoline is then worth about $1 billion in household energy consumption.  (In decimal terms, it is actually $1.4 billion.) Therefore, a sustained $10 increase in oil prices translates into $25 billion in additional household energy spending.  Assuming this price rise crowds out spending elsewhere in the economy, effectively acting as a tax, means that a sustained $10 rise in oil prices reduces annual real GDP growth by 0.2%.”[iv]

Furthermore, the three longest U.S. recessions since the Great Depression have occurred at the same time as relatively high crude oil prices.  The first followed the Oil Embargo in November 1973 and the second in 1981.  Most recently, the last recession began in December 2007 and WTI crude oil hit an intraday high of $147/barrel in July 2008.[v]

Iran’s Oil Control

Iran produces approximately 4.25 million barrels of oil per day, for about 4.9 percent of the world oil supply.  Of that amount, 2.4 million barrels per day are exported out of Iran.  More importantly, its proven reserves are approximately 137 billion barrels, or about 10 percent of the world’s proven oil reserves.[vi]  Fifty-six percent of Iran’s oil exports are to Asia and 29 percent to Europe.  While the U.S. buys no oil from Iran, China and Japan, combined, purchase over one-third of Iran’s oil exports.[vii]  Also, Iran has the fifth largest reserves of natural gas in the world, albeit much of it is undeveloped.  Because of its vast reserves of oil and natural gas, Iran’s claims that it needs to develop nuclear power for energy purposes appear deceiving.  Yet, a major problem for the country is its lack of refining capacity.  In order for crude oil to be turned into gasoline, diesel, jet fuels, and other fuels that are useful to consumers and businesses, the crude oil has to be taken through a refining process.  Because of Iran’s poor refining capacity, it has to import almost 40 percent of the oil that is consumed domestically.[viii]  Therefore, the oil sanctions imposed by the U.S., U.K., and the European Union could have crippling effects on Iran’s economy when they are implemented in July.  In response, Iran stopped oil shipments to British and French companies on February 19.  As of now, this move has little impact on supplies because only about 3 percent of France’s oil consumption is from Iranian sources and Britain has not imported oil from Iran for the past six months.[ix]  Despite this minimal impact, oil prices have already increased by almost 9 percent in 2012.[x]  While some of this increase can be attributed to the improved prospects of the U.S. economy, the events surrounding Iran have played a role too.  Participants in the global oil market point to the uncertainty over the 2.4 million barrels of oil that Iran exports each day.     

[xi]

Over the next few months, a full EU embargo on Iranian oil could be put in place.  A full EU embargo would decrease global oil supplies by 0.6 million barrels per day.  Moreover, Japan, South Korea, and South Africa all have discussed decreasing the oil they receive from Iran.  Assuming their total imports from Iran decrease by half, then 0.9 million barrels per day have been subtracted from global oil supplies.  However, it is possible that Iran could sell some of this excess supply to China or India.  Could these countries receive oil from another place?  As demonstrated by the following chart created by Societe Generale, Saudi Arabia – and to a lesser extent the United Arab Emirates, Kuwait and Qatar - has the ability to increase its oil production in order to replace the lost supply from Iran. 

[xii]

Also, last June the International Energy Agency (IEA) agreed to release 2 million barrels per day for 30 days as a result of the disruption to the Libyan oil supply.  This was the third time that the IEA authorized a release.  The other strategic releases occurred during the Gulf War in 1990-91 and in 2005 following Hurricane Katrina.[xiii]  Before the unrest in Libya, it exported approximately 1.5 million barrels per day.  Since an Iranian embargo has the potential to be more than this amount, it would not be surprising if the IEA eventually chose to issue a strategic release.  Initially, the price of WTI crude fell by more than 5 percent as a result of the announcement last June.  However, the immediate Iranian embargo could push WTI crude prices above $125/barrel over the short term.  Besides an increase in production by Saudi Arabia and a strategic release by the IEA, the other factor which would work against higher oil prices would be a decline in global economic activity.  As previously noted, a rule of thumb is that for every $10 increase in the price of WTI, annual GDP decreases by 0.2 percent.  This decline in production could dampen the demand for oil which most likely would be evinced by a decrease in the price of oil from the temporary highs. 

War with Iran

Although a partial embargo on Iranian oil exports could push crude oil prices higher, a larger impact would be felt if the current situation escalates into military strikes by Israel or if Iran shuts down the Strait of Hormuz.  In the first scenario, oil prices could increase most sharply beforehand if the military action appears almost certain.  Before the U.S. invaded Iraq in 2003, oil prices spiked in anticipation of this occurring.  When the invasion actually occurred, oil prices declined for approximately the next two months as the worst case scenario in which Saddam Hussein lit their oil on fire did not happen. 

[xiv]

Another factor that could impact the price of crude oil is the length of time that supplies are affected.  As noted by Pacific Investment Management Company, a military conflict lasting a month or less could push oil prices to record highs of around $150/barrel, but the impact could be reduced through an IEA strategic release and a willingness by Saudi Arabia and other countries to increase production.[xv]  If Iranian exports are lost for a longer time period, there could be spikes above $150/barrel.  When WTI crude oil hit $147 in July 2008, the national average for a gallon of regular gasoline was $4.11, and the average in New England was $4.15.[xvi]  These averages could potentially be breached if WTI crude prices traded above $150/barrel over an extended period of time.  In the worst case scenario, conflict with Iran could result in Iran attempting to close the Strait of Hormuz. 

[xvii]

On a daily basis ships carrying 16-18 million barrels of oil pass through the narrow strait.[xviii]  This amounts to approximately 20 percent of daily oil supplies.  Could Iran close the strait and in essence send global oil prices skyrocketing?  Since oil tankers can use only one channel to come in and one channel to come out, each of them about two miles wide, a large barrier would not have to be put in front of the strait.[xix]  Instead, Iran could use mines, missiles, or submarines to impede oil tankers.  This could cause insurers to remove coverage or increase costs for tankers around this area.  In all likelihood, this could have the same effect as shutting down the Strait of Hormuz because shipments through the strait could decrease substantially until the risks are reduced.  If this occurred, oil prices could more than double from their current levels.  If Iran shut down the strait, U.S. Defense Secretary Leon Panetta called it a red line that would spur the U.S. to react.  This increases the stakes for Iran if it was to initiate this action because it would almost guarantee military action by the U.S. and other developed nations.  It could be possible for the U.S. to maintain security by using naval escorts for oil tankers.  Their response would be caused by the potential constraints to the global economy by extremely high oil prices of more than $150/barrel.   

Conclusion

Although the U.S. and E.U. could cope with the loss of Iranian oil exports, higher crude oil prices could pose a threat to the global economic recovery.  In assessing how an investor should prepare his or her portfolio for an Iranian oil embargo or conflict, he or she could consider purchasing the stocks of some of the large oil and natural gas explorers and producers, including Exxon Mobil (XOM), Chevron (CVX), ConocoPhillips (COP), and British Petroleum (BP).  These large oil and gas majors consist of an exploration and production division and a refining division.  When the price of oil and natural gas increases, the exploration and production divisions typically obtain higher profits because their main good, oil, is increasing in price.  In contrast, the largest cost for the refining division is oil, so their profits typically decrease with higher oil prices.  Because most of the oil and gas majors derive a majority of their revenue from exploration and production, historically their profits, and stock prices, have risen when the price of oil increases.  However, this might not always be the case.  Long term investors could sell these stocks on fears of higher oil prices hurting the global economy.  As a result, holding Treasury Inflation Protected Securities (TIPS) could provide a safety hedge – investors historically flock to Treasuries during times of trouble – and as an inflation hedge against higher oil prices.  The overall impact of an Iranian conflict to an investor’s portfolio could depend on several factors including a strategic release by the IEA, the length of times supplies are limited, and the success by Iran in shutting down the Strait of Hormuz.  By evaluating the impact to his or her investment portfolio, an investor can be best prepared for this event, no matter how unlikely it currently seems.

*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass.  This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan.  The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions.

Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors, Inc. Armstrong Advisory Group and the Securities America companies are unaffiliated. Representatives of Securities America, Inc. do not provide legal or tax advice. Please consult with a local attorney or tax advisor who is familiar with the particular laws of your state. 2/12

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