Getting Iranian Oil Sanctions Right

Sanctions strategy needs an overhaul if it is to successfully help the West resolve the issue of Tehran's nuclear-weapons program.

A 1960 postcard from the Iranian Department of Publication and BroadcastingCurbing Iran's oil exports may well be the last nonmilitary option for the West to resolve its nuclear dispute with Tehran. The United States and subsequently the EU have initiated new sanctions that target oil exports from Iran. But implementing sanctions has never been easy. And with recent trends in global oil markets, it may be even harder to reach the objective today. To ensure success, the current strategy needs to be more carefully refined.

A Balancing Act

The current sanctions straddle two goals: reducing Iran's oil-export revenues and maintaining price stability in the oil markets. Iran is the world's fifth-largest oil producer, but it is also the second largest in the trading cartel OPEC. As a result, achieving both goals at the same time is a tough challenge. The National Defense Authorization Act (NDAA), which was adopted at the end of last year and spells out the U.S. sanctions, recognizes the inherent trade-off. It has been crafted cautiously to permit a degree of flexibility, allowing moderation of sanctions if the markets are not ready.

Success in stabilizing markets is far from assured. Oil prices have already spiked. In mid-April, Brent oil cost 12 percent more than at the end of 2011, when the NDAA was enacted, and 17 percent more than in early October, when momentum for sanctions started to build. Production outages in Yemen, Syria and South Sudan have contributed to this price increase. But a large share of the blame goes to Iran. Tehran has skillfully played on global fears of impending supply constraints. Threatening to close off the shipping route through the Straits of Hormuz has only compounded these worries.

As for cutting Iran's oil exports, history teaches that the risk of failure is high—the Iraq oil sanctions are just one such recent example. With world prices higher than before the NDAA was enacted, Iran can probably make up for lost revenue even if it is forced to sell less oil or sell at a discount to lure new clients. Success requires that Iranian oil-export volumes be cut dramatically for an extended period of time. Unless the present sanctions strategy is better calibrated, it probably will not achieve a major reduction in Iran's proceeds from oil sales abroad. Two issues merit closer attention.

First, oil demand is shifting away from the countries intent on imposing sanctions. Demand from countries in the Organization for Economic Co-operation and Development (OECD) is contracting, and consumption in non-OECD countries continues its rapid growth. Within about a year, oil consumption in non-OECD countries is expected to exceed OECD consumption for the first time. According to the International Energy Agency (IEA), the world will consume an additional 800,000 barrels a day in 2012, with China accounting for nearly half of that increase.

China and India, already Iran's main oil clients, are not concerned about Iran's nuclear plans in the same way as the United States and the EU. Finding the oil they need to grow their economies is a priority. If Beijing and New Delhi have to sever their oil relations with Tehran, they will need to look for new sources of supply. It is hard to predict where they will look to find the extra volumes. Without doubt, shipping discounted Iranian oil will remain enticing.

Second, crude oil is traded in a global market that is not only extremely fluid but also largely nontransparent. This provides Iran with considerable room to maneuver. As its oil is gradually displaced from Europe—which consumed about 450,000 barrels a day on average in 2011—Tehran will bet on finding new clients as well as new ways to reach them. Reshuffling its deck of oil clients may take some time. But the oil market continues to offer plenty of opportunities for Iran to maintain its exports and revenues.

The shipping industry and oil traders are also likely to aid and abet Iran's efforts to "slip the noose" of oil sanctions. While Iran’s own tanker fleet is not big enough to handle all volumes currently exported, tankers have seen significant overcapacity in recent months. Even if some of the Western shippers opt to stay away from Iran, companies from China and India are already among the largest players in shipping and physical trading of oil. A premium paid by Iran to ship its oil may continue to lure shipping companies driven by profits, not politics.

A Sound Strategy

For the United States and the EU, enforcing the global oil-trading embargo against a regime determined to evade the trap, especially one abetted by private parties lured by lucrative deals, is a high-risk effort. If the goal is to cut Iranian oil-export revenues substantially without destabilizing the markets, the current approach will need to be carefully refined.