Rippling Impacts of Iran Oil Embargoes

Discussions around the US and EU embargoes on Iranian oil generally focus on one thing: the price of oil. Iran produces 3.6 million barrels of oil a day and exports 2.5 million of those barrels, representing 3% of world supply. If the embargoes were to succeed in preventing half that oil from getting to market, oil prices would immediately jump 20 to 30%, according to the International Monetary Fund (IMF).

There's no doubt that the price of oil is important and deserves comment. But as both embargoes take effect, they will create a ripple of impacts across the oil markets that go beyond just price. From European refinery closures to a Greek default, the impacts of the embargoes would spread far beyond Iran.

Let's start with Greece. Athens has been vocal in its concern about the embargoes, as Iran has become a key supplier to the economically beleaguered country. Greece's existing contracts with Iran do not require financial guarantees, providing Athens with much-needed flexibility. To date, none of Greece's other suppliers have been willing to work on such terms, which left Greece buying 100,000 barrels of Iranian oil a day to feed 30% of its demand.

Greece's reliance on Iran is the main reason that the EU embargo does not take full effect until July 1; the bloc intends to find alternate suppliers in that time. That seemed like a workable solution until Tehran started threatening to cut off supplies to Europe immediately. No one really expects Iran to stop selling oil to its major European customers unless it absolutely has to do so, which means supplies heading to Italy and Spain are fine. Halting sales to Greece, though, is a weapon Iran could decide to fire. Iran could handle losing a 100,000-barrel-per-day customer in exchange for the financial mayhem that could ensue: The loss of access to 30% of its supplies and its only highly flexible supplier could well prove the final straw for Greece, and as we all know the consequences of a Greek debt default would spread far and wide, across the European sovereign bond market and to the euro.

So Greece is definitely a concern with respect to the Iranian sanctions. Europe's refiners are also losing sleep over the looming EU embargo, which threatens to accelerate refinery closures in Europe. Piero de Simone, head of Italy's refiners' lobby, said this in an interview with Reuters:

Asian countries not applying the embargo could buy the Iranian oil at a discount and sell cheap refined products back to us. Italy already risks the closure of five refineries and at a European level we're talking about 70 possible shut downs.

The problem is not only that Asian refiners might take advantage of exclusive access to cheaper Iranian oil to undercut Europe's refiners, but also that the playing field is becoming uneven at a time when Europe's refiners are already struggling with overcapacity and falling fuel demand. Petroplus Holdings AG, a refiner with five plants across Europe, declared insolvency last week after banks called in loans. De Simone says unless the EU creates a protection mechanism for its refiners the bloc will face a "precipitous end similar to Petroplus' for many European refineries."

Small refineries will be hit the hardest because they do not benefit from economies of scale when margins fall. Refining margins from processing Brent crude oil into gasoline, diesel, and other petroleum products already fell to a loss of 26₵ a barrel in December from a profit of 51₵ a month earlier, according to a mid-January report from the International Energy Agency.

Keeping on the infrastructure theme, another industry that will struggle with the Iranian embargoes is the shipping industry. EU sanctions on Iranian oil will extend to about 95% of the world's tanker fleet because they are insured under rules governed by European law. The International Group of P&I Clubs insures all but 5% of the world's tankers, and its 13 member clubs use European rules to govern their claim-sharing pool. Carrying Iranian oil would invalidate ships' coverage against risks such as spills and collisions. This is an aspect of the EU embargo that certainly spreads the effects far beyond the bloc's 27 member states.

Another talking point starting to surface with some regularity around the Iranian issue is whether EU countries will tap into their strategic reserves to compensate for the loss of Iranian oil. We mention this here only to emphasize that strategic reserve releases can only ever have limited, short-term effects. According to the European Commission – which coordinates maintenance of these emergency stocks – the bloc's 25 nations excluding Romania and Bulgaria had total oil reserves of 134.5 million tonnes. That is equivalent to just 120 days of demand if the stocks were totally drained, which countries would never do. An announcement that Italy or Spain were tapping strategic reserves would likely push Brent crude oil prices down, but the impact would be relatively small and within a few weeks would have worn off completely.

And finally, let's talk about oil supply, demand, and prices. Iran sells 2.6 million barrels of oil per day into the global markets, representing 3% of world supply. The embargoes may be aimed at halting that flow completely, but the more likely scenario is that much of Iran's crude oil will continue to flow to customers willing to violate or find ways around the rules. The two biggest such customers? China and India, who as Iran's only major clients will be able to buy oil at reduced prices. India recently declared publicly that it will not cut back on oil imports from Iran, because its emerging economy needs the supply.

As for the rest of the world, prices will rise somewhat because Iran will not be able to find buyers for all of its available crude, decreasing world supplies. Oil-industry executives meeting in Davos said energy markets could afford to lose half of Iran's exports (an amount roughly equivalent to the supplies lost during Libya's civil war) because OPEC members officially have about 2.85 million barrels a day of spare crude oil production capacity. Outside of OPEC, Russia stands to gain from the sanctions – even though many Europeans still carry misgivings about relying too heavily on Russia for oil and gas after its gas transit disputes with Ukraine led Russia cut off supplies in 2005, Russia is still an obvious source of increased oil supplies if needed.

Oil embargoes against Iran will hurt the Iranian economy. The government in Tehran relies on oil exports for half of its budget and, even though President Mahmoud Ahmadinejad has repeatedly assured the world that his country can survive any sanctions, even he had to backtrack on those assurances last week. Ahmadinejad's government raised the banking interest rates to 21% from 15% and devalued the rial by 8%; these moves are intended to help stabilize the currency market. The rial has plunged 30% in the last month as many Iranian looked to sell rials for gold and other currencies.

However, oil embargoes against Iran will not only hit Iran – the global oil machine is global indeed, which means a limitation on one part sends shudders through the rest. Hold onto your steering wheels, 'cause we're in for a bumpy ride.

[All this turbulence in the oil markets adds to the challenge of investing profitably in the energy sector. As the world is running out of oil, other sources of energy will take center stage. Be prepared to profit from these changes by positioning yourself now.]