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Closing Iran’s Oil Spigot

From the Magazine: Wednesday, October 8, 2008

There’s one last chance for a peaceful resolution to Iran’s nuclear ambitions.

What happens next in the standoff with Iran over its nuclear program will depend upon decisions taken by statesmen in Brussels and Beijing. If the European Union and the Chinese government were to follow the United States and enforce a ban on investment in Iran’s oil sector, it could provide the leverage the United Nations Security Council has thus far lacked in its dealings with the Iranian government. With crude oil selling at record high prices, it may be the worst possible time to squeeze Iran’s future oil production. But an international investment ban may also be the last best chance to achieve a peaceful outcome to the Iranian nuclear issue.

Since the world first learned in 2003 about Iran’s previously covert nuclear program, the United States and the European Union have attempted to organize an international diplomatic effort to rein in the project. After five years of steadily increasing efforts by the West, the results have been dismal. Iran continues to reject all entreaties to suspend its enrichment of uranium and is instead expanding its enrichment program. The U.N. Security Council has passed four resolutions requiring Iran to halt uranium enrichment, without any effect on the Iranian program. Neither the Security Council nor the West has employed sufficiently powerful leverage against Iran, leverage that would change Iranian behavior.

The Iranian government is highly dependent on the revenue it receives from crude oil exports. Income from Iran’s oil exports constitutes 85 percent of the Iranian government’s revenue. Yet Iran could face a financial crisis early next decade due to a possible drying up of its oil export income. The United States, Europe, and others concerned about Iran’s nuclear ambitions could achieve the leverage over Iran that they have thus far lacked if they implemented policies that helped strangle Iran’s oil income. Without its oil income, Iran’s government would be hard pressed to maintain social order. Fearing for its survival, the regime would be under great pressure to deal constructively with the United States and the Europeans over both its nuclear program and other international security issues.

Iran’s looming financial crisis

In 2006, Iran was the fifth largest oil exporter in the world. How is it possible that by the middle of the next decade its exports could fall to zero?

In a paper published in January 2007, Roger Stern, a researcher at Johns Hopkins University, predicted that Iranian oil exports would drop to zero by 2014–2015. Stern estimated that Iran’s future investment in oil production capacity would be insufficient to offset the natural production decline of its existing oil fields. Meanwhile, domestic Iranian demand for oil products would continue its rapid growth. Stern predicted that as early as 2014, rising Iranian oil product consumption would surpass falling Iranian crude oil output, leaving no net oil output for the global export market. Iran’s oil income would have thus dried up.

Iran could face a financial crisis early next decade due to a drying up of its oil export income, which constitutes 85 percent of the Iranian government’s revenue.

Iran’s looming oil export crisis is partially self-inflicted. Iran depends heavily on foreign expertise to boost production from existing fields and to develop new ones. However, the Iranian government prohibits foreign ownership in its oil sector. Sharing oil revenues with foreign oil development partners has been highly unpopular inside Iran and has made negotiations with potential development partners troublesome.

Meanwhile, Iranian consumption of crude oil products has expanded at about a 4.9 percent compound annual rate this decade. Government subsidies have held the retail price of gasoline far below the market price, leading to a 10 percent per annum growth rate in Iranian gasoline consumption over the past six years. The rapid growth rate in gasoline consumption, combined with problems and mismanagement in Iran’s oil refining sector, has resulted in Iran importing roughly half of its daily gasoline requirement. The government recently responded to this drain on foreign exchange by imposing a rationing system on consumers. Although highly unpopular with the public, these measures may check for a time the growth of Iran’s oil product consumption.

It has been over two years since Stern finished his paper and submitted it for peer review. Is his forecast holding up? Iran’s net oil exports slipped from an average of 2,469 thousand barrels per day in 2006 to 2,294 thousand barrels per day in 2007, a 7.1 percent decline. Iranian crude oil production averaged 4,028 thousand barrels per day in 2006, but decreased to 3,870 thousand barrels per day in May 2008, a 3.9 percent drop. We don’t yet have data on Iranian oil consumption during 2008. But if the Iranian government wishes to maintain net oil exports, it will have to further tighten its gasoline rationing system, with all of the political risk that entails.

Oil prospecting in Tehran

In his paper, Stern discussed four scenarios for future Iranian oil exports. The key variable in these scenarios was what investment would occur in the Iranian oil sector in order to maintain or expand output. In what he regarded as the most likely scenario, Stern predicted that Iranian oil exports would drop to zero by 2014–2015, about nine years after he finished his study. Stern assumed that oil field projects scheduled to begin by 2008 would occur, but that no new significant project would start after that. Iranian production would hold up until 2010 or so, but net exports would then begin a steep decline.

Iranian oil exports could drop to zero by 2015 because investment in production capacity will be insufficient to offset the natural production decline of existing oil fields.

This should be a chilling prospect for the Iranian regime, and should provide an incentive for Iran’s leaders to become more open-minded about taking on foreign partners in the oil exploration business. And in spite of the difficulties and risks of operating in Iran, the sky-high price of crude oil should provide an incentive for foreign partners to show up in Tehran, since there would be plenty of profit to go around. With global oil prices where they are, the sanctions imposed on Iran thus far by the U.N. Security Council, Europe, and the United States will not likely be sufficient to dissuade future investment in Iran’s oil sector.

The price of oil has more than doubled since Stern completed his paper. For his predicted collapse of Iranian oil exports to occur, the international community will need to do more to ensure an effective cutoff of foreign investment in Iran’s oil sector. The U.S. Treasury has long banned U.S. investors and managers from Iran’s oil sector. And in 2006, the Japanese government persuaded a Japanese oil exploration firm to largely abandon a development deal it had made with Tehran, even though in 2006 Japan was Iran’s largest oil customer and Japan received 8.7 percent of its daily crude oil requirement from Iran.

More prospective oil partners will have to join the Iranian oil investment ban. Attention now focuses on the European Union, which is considering an investment ban, and China.

China’s Persian headache

In 2006, China was Iran’s second largest customer and received 4.7 percent of its daily crude oil requirement from Iran. Iran’s relentless nuclear program has placed China’s leadership in an uncomfortable predicament. China’s imports of crude oil have grown at a compound annual rate of 19.3 percent over the 10 years ending in 2007. The rapid growth of China’s oil imports has made Iran an important supplier of China’s economic growth. China’s social stability, and thus the survival of the regime in Beijing, may depend on the arrival of more and more crude oil tankers from Iran.

Over the past three decades China has carefully conducted its foreign policy in a way to avoid confrontations with the West. China’s economic growth, and thus its social stability, has depended on imports of capital, technology, and management skill from the West, combined with exports of finished goods to these same markets. China’s foreign policy has sought to preserve this arrangement. Iran and its nuclear ambitions may force the Chinese leadership into a difficult choice between oil from Iran or its political and commercial relationship with the West. The pressure on China would rise exponentially should the European Union decide to follow the Americans and implement a ban on Iran’s oil sector. If the EU implements a ban and the Chinese government responds by stepping up the activities of its oil companies inside Iran, China should expect its relations with the West to deteriorate.

Three ways to pay for Iran’s nuclear program

This is obviously a poor moment in history for statesmen to contemplate a policy that if successful would remove 2.3 million barrels per day from the global oil market (about 7 percent of daily global oil imports). It would have been much less painful to starve Iran’s oil sector when global spare production capacity was large, or when Iran’s revenue per barrel was a small fraction of what it is today.

If Stern is right and Iran’s oil exports fall to zero over the next six years, what effect will this have on global crude oil prices? Oil markets might already anticipate this scenario, although that is difficult to judge. As Europe’s statesmen ponder whether to join the American investment ban on Iran, they will have to consider whether the cost of losing Iran’s oil exports will be too much for the global economy to bear.

Iran’s net oil exports slipped by 7.1 percent from 2006 to 2007, from 2,469 thousand barrels per day to 2,294 thousand. Iranian crude oil production has declined by 3.9 percent.

However, the world is going to have to pay in one way or another for Iran’s nuclear ambitions. Iran repeatedly asserts that its nuclear program is entirely peaceful. The International Atomic Energy Agency cannot verify this claim because Iran refuses to grant adequate access to the IAEA’s inspectors or to address suspicions about Iranian nuclear weapons research. And Iran declines to implement the Additional Protocol safeguard agreement, which would provide a more comforting level of transparency about its nuclear program.

Thus, even those in the Middle East who might wish to grant Iran the benefit of the doubt will feel compelled to take measures to defend their security. It should not be a surprise that energy-producing giants such as Saudi Arabia, Kuwait, Bahrain, and the United Arab Emirates, along with Egypt, Jordan, and Turkey, now suddenly have an interest in their own nuclear programs.

One policy choice is to accept Iran’s arrival as a nuclear power and to “contain” Iran by allowing a regional balance of power to develop. But along with containment would come a highly unstable and three-sided nuclear and ballistic missile arms race as Iran, Israel, and Saudi Arabia faced off against each other. Missile flight times would be very short, command and control systems would be fragile, and retaliatory forces would be vulnerable to first-strike destruction. Those with nostalgia for the stability of the Cold War will not find this prospective Middle East standoff remotely as stable. It would take a miracle to avoid a conflict.

Another policy option is a preemptive military strike against Iran. There seems to be no serious interest inside the United States for such an action. Israel, on the other hand, may find itself required to mount a strike, as it has in the past against both Iraq and Syria. We have no way of reliably forecasting how a war between Israel and Iran would escalate or where the destruction would stop. The resulting damage to the Persian Gulf’s oil infrastructure could be very painful.

Decision time in Brussels and Beijing

Creating diplomatic leverage against Iran with an international investment ban seems like a reasonable option when compared to the alternatives. Every choice has its risks and costs. Implementing an international investment ban on Iran’s oil sector could be effective, peaceful, and less costly than any other option.

The West is looking for meaningful diplomatic leverage against Iran without resorting to force. Should China and its oil companies undermine what the West will see as the best hope for a peaceful solution to the Iranian problem, China’s diplomatic position with the West would deteriorate as the Iranian crisis inevitably intensified. This could threaten China’s political, economic, and financial links with the West, and could deepen concerns about China as a future security challenge.

In what may be the last chance to peacefully resolve this conflict, the European Union needs to cut off Iran’s oil sector. China’s leadership will then face its own moment of decision, with grave consequences for the Middle East, China’s relations with the West, and China’s own stability.

Robert Haddick is the founder of Westhawk, a website on national security issues. He was an officer in the U.S. Marine Corps and a consultant for the Fremont Group, a private investment firm affiliated with the Bechtel Group. He last wrote for THE AMERICAN on how China’s military and economic rise resembles that of pre–World War I Germany.

Photograph by AP/Vahid Salemi.

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