01/23/2012 – Iran is threatening to close the Straits of Hormuz. Newly tightening financial sanctions on Iran’s banks and its central bank are suffocating credit for Iran’s fuel imports and oil exports. Inside Iran there are widespread frantic efforts by businesses and people in the streets to convert Rials to US dollars. Long lines are developing for gasoline and diesel. Repeated requests to Iran’s government to slow or halt its nuclear enrichment projects are being rejected. Iran seems to be stepping up the pace of nuclear weapons development. Israel is being warned by the US Government to avoid direct conflict with Iran now and instead wait for the newly tightening financial sanctions to work effects through Iran’s power structure.
The world economy is slowing. Under ordinary circumstances, oil prices would be falling as demand weakens. However, oil markets are instead being levitated by fears of possible military conflict and interruption of supplies through the Straits. As the saber rattling increases, so does the cost of oil. At the first sign of armed conflict oil could run up to $150/barrel; and if armed actions were to be sustained $200/barrel would be conceivable. US consumer spending would be immediately affected as gasoline prices would escalate to $5/gallon or more, and distribution costs in the US economy would escalate along with the price of diesel fuel.
There would also be secondary effects: Shipping companies would respond to higher diesel costs by slowing speed of their ocean-going tankers to conserve fuel. The pace of global flow of oil would slow. Insurance costs would escalate at the first sign of risk to tankers. Given the high value of cargoes, insurance premiums would escalate. Aircraft fuel costs would also escalate worldwide, disrupting transportation of high value-added cargoes which tend to move by air rather than by sea. Consequent disruption or surges in costs of international industrial supply chains would have negative impact on world manufacturing.
An oil spike might not by itself bring the US economy to a standstill but, functioning like a huge tax increase, would cut consumption dramatically. Europe agreed to ban imports of Iranian oil in principle, although phasing in of a ban will take place only gradually. In conjunction with the current slide into recession in most of Europe, the Euro is also weakening against the dollar. This will raise costs of oil and refined products even more as oil is paid in dollars. The impact on Europe of oil spiking by 50% would be disproportionately greater, tilting Europe into even deeper recession.
Further European distress would be negative for the US outlook. In response, the Federal Reserve would likely respond with increased monetary stimulus, flooding the world with US dollars in an effort to shore up the global banking system and stem the dollar’s appreciation as worldwide capital flight occurred. The Administration would likely feel politically compelled to pump oil freely into the market from its strategic reserves in a frantic effort to keep gasoline prices down before elections. The Administration would also feel political need to respond with threats of overwhelming force, in hopes that such threats would deter Iran from any actions that exceeded rhetorical taunts.
In Iran, a higher price of oil might theoretically be beneficial to Iranian revenues, but Iran itself would be severely damaged by interruption of transportation through the Straits, as Iran would suffer interruption of its own shipments of oil and cessation of its imports of refined gasoline, aircraft fuel, and diesel. Increasing severity of fuel shortages in Iran would encourage greater social unrest, generating much discomfort for the present complex power structure of religious theocracy and Revolutionary Guards officers.
It is possible that a limited confrontation in and around the Straits would be brief, with both sides backing off from extreme action that might involve sinking a US Naval ship or an Iranian submarine. Nonetheless, markets might continue apprehensive for weeks or perhaps months, levitating oil prices well beyond the peak of a confrontation. On the other hand, an Iranian attempt to close the Straits would bring about a sustained US military action to suppress Iran’s capabilities. US military forces would ultimately succeed, but this would likely include a number of air sorties to take out Iran’s land-based missile capabilities, and efforts to destroy or frighten away a number of its ships and submarines over a period of weeks.
In response to full deployment of American sea and air power, Iran would likely back away from direct military confrontation and its devastating, humiliating consequences.
However, a military backdown would likely be accompanied by a change in Iran’s tactics to alter the overall balance of negotiating leverage in Iran’s favor. Iran would likely shift its pressure on the US and its European allies through stepped up terrorism in the region, including disruption of pipelines and encouragement of insurrections in locations like Bahrain and some of the other Sunni kingdoms. It would not be surprising if large numbers of Iran’s Revolutionary Guards (IRG) were to be sent into Iraq, on the pretext of assisting the Shia government to protect itself from Sunni violence, but with intention of placing IRG forces next to the Saudi oil fields.
For historic reasons, many analysts tend to focus on a potential Israel-Iran conflict, but an entirely different process of Iran-led Shia conflict with all Sunni leaders is a potential next phase in the never-ending Middle East turmoil. Religious and tribal rivalries between Sunni and Shia were suppressed for much of the last century by Europeans, and more recently by the US. With US withdrawal from Iraq and soon from Afghanistan, a field of opportunity has been opened for Iranian-Shia expansionism. While most market analysts remain focused on potential Israeli action against Iran, a more likely process of turmoil in the Middle East will take the form of renewed Sunni-Shia conflict, with Iran seeking political-military dominance throughout the oil-producing region and beyond to surrounding enclaves of Shia populations.
It is this concern that most worries the Saudis, UAE, and other Sunni-led entities. They fear a nuclear Iran because they fear that an Iran with a backstop of nuclear weapons would be an existential challenge to them. If a nuclear weapon were to be used, they worry that Iran would not direct its application or threat of application to Tel Aviv or New York, but rather to Riyadh.
The ongoing uncertainties in the Middle East, particularly driven by Sunni-Shia rivalries and Iranian ambitions for preeminence, will leave oil supplies and prices subject to frequent moments of anxiety or apprehension in markets well into the future. A single point of confrontation between Iran and the US in the Straits is likely to be transformed into a multiplicity of smaller points of conflict throughout the Gulf and into the Levant, making it increasingly difficult to craft appropriate responses and disincentives to restrain Iran.
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