Business Economics Vol. 47, No. 3 r National Association for Business Economics

Impact of a Middle East Oil Export Disruption PHILIP K. VERLEGER Jr.n Two ways that oil exports from the Middle East can be disrupted in the current political climate are sanctions on Iran and Iran blockading the Strait of Hormuz. In considering the impact that these actions might have on the United States and other oil importers, it is important to consider such factors as characteristics of the blocked oil, how other exporters might react, and the possible release by importers of strategic reserves. The paper also provides some historical perspective on how past supply disruptions were resolved. Business Economics (2012) 47, 197–201. doi:10.1057/be.2012.11

Keywords: oil exports, supply disruption, Iran, Strait of Hormuz, sanctions

T

here are two plausible ways that deteriorating political relations with Iran can impact oil markets. The first is the imposition of sanctions on Iranian oil exports by major oil-importing countries. The second is the use of Iranian military force to close the Straits of Hormuz, blocking sea-borne exports from Persian Gulf oil exporters, including eastern Saudi Arabia. 1. Sanctions on Iran Sanctions on Iran should not by themselves have any significant impact on oil prices because Iran plays a much diminished part today relative to its past position. As can be seen from Table 1, Iran may have net crude exports of approximately two million barrels per day. In addition, Iran probably

exports around 500,000 barrels per day of natural gas liquids. The oil volumes that sanctions may prevent Iran from exporting can be easily replaced, assuming other oil-exporting countries boost production to replace the loss and/or consuming countries release an offsetting amount of oil from strategic stocks. (This is an important assumption that I discuss further below.) OPEC surplus capacity today stands at roughly four million barrels per day, according to Energy Intelligence Group estimates. As can be seen from Figure 1, this surplus has declined recently but still exceeds total Iranian exports by a wide margin. The available oil will also satisfy the needs of global refiners. In the past, product and crude oil prices have risen significantly when light sweet crude supplies were disrupted. The price doubling in 2008 was caused, for example, by the cutoff of 500–700 thousand barrels per day of Nigerian sweet crude output. Prices rose because other producers could not match the quality of these volumes. The 2010 price increase can also be traced in part to lost sweet crude supplies from Libya. The loss of Iranian crude does not create such problems. Iran produces Middle East sour crude with no unique characteristics. It can be replaced. The lost Iranian exports must, however, be offset to avoid a price increase. In the past, some oil-exporting countries have cut production opportunistically when global markets were tight. Obviously, every producer enjoys increased market power when world crude output is near capacity. Given the very low short-term price elasticities of demand, any nation exporting more than 1.1 million barrels per day can increase revenue by cutting

Based on a panel presentation on “Impact of an Iranian Blockade on Oil Markets and the Economy” at the 2012 NABE Policy Conference, March 26. n Philip K. Verleger, Jr. is the Owner and President of PKVerleger LLC and is the David E. Mitchell/EnCana Professor of Management at the University of Calgary’s Haskayne School of Business. He writes and publishes The Petroleum Economics Monthly. He began his work on energy as a consultant to the Ford Foundation Energy Policy Project in 1972. He then served as a Senior Staff Economist on President Ford’s Council of Economic Advisers and Director of the Office of Energy Policy at the U.S. Treasury in President Carter’s administration. He has been a Senior Research Scholar and Lecturer at the School of Organization and Management at Yale University, a Vice President in the Commodities Division at Drexel Burnham Lambert, and a Senior Fellow at the Peter G. Peterson Institute for International Economics. Verleger earned his Ph.D. in Economics from MIT in 1971.

Philip K. Verleger Jr.

2. Closing the Strait of Hormuz

Table 1. Rough Estimate of Iranian Petroleum Supply/Demand Balance (Million barrels per day)

Crude oil production Estimated petroleum consumption Net exports

Q1:11

Q2:11

Q3:11

Q4:11

3.63 2.09

3.65 2.05

3.53 2.04

3.55 2.04

1.54

1.60

1.49

1.51

Source: IEA.

Figure 1. Monthly OPEC Surplus Capacity, 1999–2011 9

Million Barrels per Day

8 7 6 5 4

Oil markets may be affected significantly, however, if Iran attempts to close the Strait of Hormuz. A loss of supply from other Persian Gulf countries would send prices much higher without a strategic stock release. The threat of a Hormuz disruption has dominated policymaking for decades, at least four to be exact. President Nixon spoke of the danger in his first energy messages. His successors all discussed the issue at one time or another. Today, the economic risks associated with a disruption are significantly lower due to preemptive measures and other developments. Three critical factors have eased exposure to cutoff of the Persian Gulf. First, pipelines have been constructed to bypass Hormuz. Second, consuming countries have built strategic reserves. Finally, oil use is beginning to fall rapidly, particularly in the United States.

3 2

Pipelines 2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

0

1999

1

Source: PKVerleger LLC.

production. This means OPEC members Angola, Iraq, Nigeria, Kuwait, United Arab Emirates, and Venezuela all could push prices higher just by offering less oil to buyers. Historically, several of these nations apparently exercised their newfound power, cutting sales just enough to add further upward pressure to prices. Their oil ministry officials seem to understand that consuming countries are clueless regarding this ploy. These officials also recognize that their counterparts in consuming nations count barrels rather than watch prices. This focus on quantity means consuming countries will remain ignorant of any exporter shenanigans for weeks if not months, thus enabling the latter nations to boost revenue. Oil buyer representatives, particularly major oil company executives, could tip off the consumers to such producer actions. Many oil firms have a conflict, though, because they also benefit from higher prices. Absent such market manipulations, the sanctions that force Iran to cut exports should have no impact on crude prices.

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The pipelines have dramatically cut the threat of a Hormuz closure. While 17–19 million barrels per day of crude flow through the Gulf in peace time, up to six million barrels per day can be diverted to ports elsewhere. By the end of 2012, this figure will rise to eight million barrels per day. As can be seen from Figure 2, the oil volume moving through the strait could drop as low as 10 million barrels per day if Iran attempted to interdict supplies. Within two to three years, additional pipelines will be completed that will divert greater volumes. Strategic reserves Producing and consuming countries have also developed strategic crude stocks that can be released in a crisis. In March 2012, Saudi oil minister Naimi told a press conference that his government had positioned 10 million barrels of strategic reserves in Japan and additional stocks in Rotterdam to draw on if needed [Dourian 2012]. In addition, consuming countries hold 1.5 billion barrels in government-controlled stocks. These could be released at a rate of 14 million barrels per day during the first month of a crisis, according to Reuters. Reuters also noted that the stock release would include 10 million barrels per day of crude and four million barrels per day of product [Mackey and Mably 2011]. The Reuters report claimed this number was confirmed by IEA officials.

IMPACT OF A MIDDLE EAST OIL EXPORT DISRUPTION

Figure 2. Crude Oil Volume through the Strait of Hormuz, Actual and Bypass Scenario, 1965–2011 and Projected to 2014 25

Decline of U.S. petroleum consumption

Million Barrels per Day

Bypass No Bypass 20

15

10

5 1965

1970

1975

1980

targeted release and distribution worked as intended.”

1985

1990

1995

2000

2005

2010

Source: PKVerleger LLC from historical BP data.

Presumably a Middle East supply disruption should have no price impact if consuming nations can, in fact, release the volumes reported by Reuters. Edward Morse [2012] questioned these numbers, however, noting that the U.S. Strategic Petroleum Reserve was able to deliver only 500 thousand barrels per day during the June 2011 release even though the theoretical capacity is 4.4 million barrels per day. Morse attributes the 90 percent shortfall to structural changes: The SPR was designed to pull inventory directly into pipeline systems moving oil from the U.S. Gulf Coast inland. Over the last decade, most of the lines have been reversed and the latest data show around less than 800,000 b/d flowing north due to the miracle growth of Canadian oil sands and U.S. shale oil output, the fastest growing oil production in the world. But now logistics require mostly seaborne exports and port congestion impedes tanker loadings at SPR terminals such that the oil cannot be brought out at any more than one seventh of the planned rate into pipelines.

DOE has taken issue with Morse. Platts reported that the department disputed Morse’s calculation and “is confident that, if needed, it could effectively react to a situation requiring the movement of 4.25 million b/d” [Gordon 2012]. The Platts report included DOE’s explanation of the 2011 SPR crude release: “This was an intentionally targeted release of light sweet crude to counteract the specific and unique effects of the Libyan situation at the time,” the agency said. “The

Finally, U.S. petroleum consumption is declining rapidly. In the United States, data from the Bureau of Economic Analysis (BEA) suggest gasoline use has been dropping by roughly 6 percent annually from prior-year levels, and the rate of decline is accelerating. The consumption drop is quickly reducing the U.S. economy’s sensitivity to sharp petroleum price increases or decreases. The BEA data differ from Department of Energy (DOE) statistics, which show a lower rate of decrease. Here, I accept the BEA data as gospel because the agency employs qualified statisticians who actually try to measure consumption. DOE, in contrast, makes no such effort. Instead, it backs into its estimate based on industry reports on production and inventory changes, combined with “guesstimates” regarding import and export volumes. In my view, the DOE calculations are little better than random numbers. 3. Likelihood of Disruption and Estimated Impact on Supply A disruption that temporarily stopped the Strait of Hormuz oil flow could cut oil supply to the world market, if Morse is correct, even if the IEA ordered members to release oil at maximum rates. The global market could be short as much as two to four million barrels per day for some time. Removal of mines and clearing of obstacles by allied navies might not end the effective blockade if ship owners, worried about attacks, refuse to send vessels into the Gulf. The result would be a sharp price increase. Many authorities doubt this will happen. (One skeptic, Saudi minister Naimi, told a reporter, “I think if you believe Hormuz will be closed, I will sell you the Empire State Building or the Egyptian pyramids [Dourian 2012].”) In my own view, we still need to consider possible consequences. In evaluating this threat, one must examine the supply-and-demand imbalance as well as the added pressure from hoarding or risk-averse buying. In past disruptions, Asian buyers have been particularly aggressive when supplies were threatened. Japanese buyers, for example, rushed to buy crude following the Shah of Iran’s fall in the late 1970s [Blas 2012]. In recent weeks, the Financial

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Philip K. Verleger Jr.

Times has reported that Thailand, South Africa, India, and China are hastening to build inventories, which the Financial Times referred to as hoarding [Blas 2012]. Buyers from these countries would likely move quickly to buy crude should the Hormuz oil flow be disrupted. The Japanese might join them. Given this background, one must worry that a market imbalance of between one and five million barrels per day might develop, depending on the response of IEA countries and other actions taken by consuming nations, discussed below. Such a disruption would lead to a supply imbalance of between 1 and 5 percent. Given the very low shortterm price elasticity of demand for crude oil, estimated here to be around 0.04, one should expect price increases somewhere between 28 and 150 percent. Prices might spike to double this before settling at these levels. Such increases would be consistent with those observed in the 1990 disruption after Iraq invaded Kuwait. To illustrate, I show in Table 2 calculations of a one million barrel per day disruption (Iran sanctions) and a five million barrel per day disruption (closure of the Strait of Hormuz). Also shown are the estimates for 1990 made using the 0.04 elasticity. This predicted an 87 percent price increase in 1990. The actual rise came in at around 85 percent. Should these estimates be believed? While they are consistent with past market behavior during disruptions in 1990 and other episodes, I am skeptical for several reasons. First, such a price increase

would require banks to fund crude oil buyers with ever larger letters of credit. Today, a firm buying one million barrels of crude must open a letter of credit for $120 million. It is not clear that banks would willingly double credit lines. While Chinese companies would probably be able to obtain credit, firms from other Asian countries would face difficulties. U.S. and European companies would have trouble as well, especially given the fact that many European banks that traditionally financed commodity trade have curtailed or ended their activity. Stephen Cecchetti, head of the Bank for International Settlements’ Monetary and Economic Department, emphasized the European banks’ inability to increase lending for any reason recently, noting, “Do not expect banks to respond (to the increased liquidity provided by the European Central Bank) by increasing their lending.” He then added, “Financial conditions have improved, but they are still strained” [Ewing 2012]. Second, one must expect to see many speculators and passive investors forced from futures markets. The cost of carrying a long futures contract would rise several-fold at the start of a disruption because margin requirements would increase. Exchanges might require full deposits. Furthermore, if the price increase becomes extreme, the U.S. Commodity Futures Trading Commission (CFTC) might order trading for liquidation only or even halt trading. While such action would outrage many, the current CFTC chairman, Gary Gensler, seems inclined to use any and all of the Commission’s emergency powers.

Table 2. Scenario for Crude Price Rise that Might Follow Temporary Closure of the Strait of Hormuz Absent Release of Sufficient Strategic Stocks vs. 1990 Iraq/Kuwait Experience

Base oil demand (Million barrels per day, or MBD) Supply loss after strategic reserve release (MBD) Percentage loss in supply Elasticity of crude price with respect to percentage loss in supply Predicted price increase (percent) Starting price (dollars per barrel) Predicted equilibrium price (dollars per barrel) Likely price level (dollars per barrel) Source: PKVerleger LLC.

200

Disruption of Iranian Exports in 2012

Disruption of Persian Gulf Exports in 2012

Third-Quarter 1990 after Iraq Invades Kuwait

87

87

66

1

5

2.3

1.149 0.04

5.175 0.04

0.035 0.04

28.7 126.00 162.21

143.7 126.00 307.03

87.121 20.00 37.42

140.00

185.00

—

IMPACT OF A MIDDLE EAST OIL EXPORT DISRUPTION

Third, some firms that have acquired inventories on a cash-and-carry basis (buying physical oil and selling futures) might have to liquidate stocks because they cannot meet margin requirements. These stock sales would reduce the supply-and-demand imbalance and depress prices. For these reasons, any price increase associated with a closed Strait of Hormuz should be small, probably on the order of one-third to one-quarter of the numbers in Table 2. Furthermore, I would expect to see prices drop precipitously once the problem passed. Recall that prices declined 33 percent in January 1991 when it became clear that Iraq could not disrupt markets. Thus, world crude prices could fall to $90, or even $80, per barrel once the world realizes that Iran can no longer disrupt the oil flowing through Hormuz.

REFERENCES Blas, Javier. 2012. “Fears over Conflict Fuel Hoarding,” Financial Times (March 23). Dourian, Kate. 2012. “Transcript of Press Conference by Ali Naimi,” Platts on the Net (March 21). Ewing, Jack. 2012. “Report Shows Depth of the Distress in Europe,” The New York Times (March 11). Gordon, Meghan. 2012. “U.S. Defends SPR’s Potential for Quick Response to Oil-Supply Emergencies,” Platts Oilgram News (March 1). Mackey, Peg, and Richard Mably. 2011. “Exclusive: West Readies Oil Plan in Case of Iran Crisis,” Reuters (January 6). Morse, Edward. 2012. “Cushions to Stem Iran Oil Price Spike are Proving Elusive,” Financial Times (February 27). Verleger Jr., Philip K. 1983. Oil Markets in Turmoil. Ballinger Press.

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