Over a Barrel

by Michael Makovsky, Ed Morse | May 29, 2009

As the Obama administration prepares to engage Iran diplomatically, sentiment in Congress is rising in support of applying greater pressure on Tehran. The current centerpiece of this strategy is legislation recently introduced by a bipartisan set of congressional leaders to sanction companies that sell gasoline to Iran or help upgrade Iran’s gasoline refining capacity. Despite the appeal of leveraging Iran’s apparent dependence on imports of refined petroleum, the legislation is unlikely to have much impact. Moreover, valuable time could be wasted while Iran continues its ever more rapid march toward nuclear capability. The only effective option for seriously limiting its gasoline imports is to impose a naval blockade on Iranian ports, which should only be undertaken, if needed, after proper and complete preparation.

 

Iran is certainly in a position to be pressured by economic levers. Obama’s pursuit of diplomacy is occurring amid a collapse in oil prices, which has undermined the Iranian regime’s economic standing and confidence. The 60-percent drop in oil prices since July has rapidly transformed Iranian budget surpluses into deficits (oil exports contribute almost two-thirds of all state revenue), undercutting the government’s ability to buy political allegiance through subsidies and social spending and to fund its nuclear program. In the first three months of 2009, Iran earned $9 billion from oil exports, down from a quarterly average in 2008 of $21 billion. On an annualized per capita basis, that means a decline from $1,250 to $430.

Lower oil prices, combined with the rise in spare global oil production capacity, reduce Iran’s ability to fund surrogates in the region, trim its diplomatic leverage among net energy consumers, and make a military strike on its nuclear facilities more conceivable by damping its consequences for the global economy.

So as Iran continues to make less and less money from its oil exports, Congress is now trying to apply economic pressure via its gasoline imports. Though Iran has enough oil to meet its domestic needs, it lacks the sufficient capacity to refine the oil. Legislation proposed in the House and Senate would amend the 1996 Iran Sanctions Act to sanction companies that supply refined petroleum products to Iran or provide insurance or shipping for delivery of these products, or assist Iran in upgrading or maintaining its refineries. Supporters--who now includes half the Senate--hope this approach would raise the cost Iran pays for gasoline, increase domestic political pressure on Tehran, and send a tough signal to stop its nuclear development. As Obama said last year, preventing Iran from “importing the gasoline that they need” would change its “cost-benefit analysis.” (The administration appears to be backing off that idea for now; Secretary of State Hillary Clinton said on May 20: “Until we have tested within the timeframe set forth by the president where we think this engagement is going, I'm not sure that adding new unilateral sanctions is really that helpful.”)

Placing aside the issue that the U.S. government has not consistently and aggressively enforced the current iteration of the Iran Sanctions Act, ramping it up to limit Iran’s gasoline imports is unlikely to have a significant impact on the country. Through rationing and expanding its capability to refine natural gas into gasoline, Iran has managed since June 2007 to reduce its gasoline imports from 40 percent of total domestic consumption to 25-30 percent without undue political fallout. This lowers the potential political cost to Tehran of a sharp reduction in gasoline imports.

Moreover, with so many gasoline suppliers in the world--including Russia and China, over which the United States has limited leverage--it would be difficult to enforce any embargo short of a military-backed blockade. While refining capacity has been tight globally in recent years, South and East Asia alone are adding 2.5 million barrels/day of new refining capacity this year at a time when global demand is falling by 2 million barrels/day.

 

If the United States is committed to using an energy lever, the only effective one available is to deploy a naval blockade to interdict Iran’s gasoline imports, and possibly its oil exports. Since this would be tantamount to an act of war, it should only be initiated by the United States and its allies after diplomacy and financial sanctions have failed, as a last measure short of a military strike on Iranian nuclear facilities.

Iran might well react to a blockade or a military strike by sabotaging the oil sector in southern Iraq, jeopardizing 1.8 million barrels/day of oil exports for possibly several months. If Iranian oil exports were also halted, by the Iranians or us, it could mean the loss of close to 4 million barrels/day, or close to today’s global spare production capacity. Iran could also attack other Gulf energy facilities or attempt to close the Strait of Hormuz, through which about 20 percent of the world’s oil exports pass.

If the U.S. is contemplating a blockade or military strike, then it must prepare to mitigate any spike in energy prices that might result from a conflict. Several measures are called for, some of which can be accomplished in the near-term while others will require longer lead times.

First, the U.S. Department of Energy needs to test different release rates of its Strategic Petroleum Reserve (SPR), which stores about 700 million barrels of crude oil as a strategic cushion. The SPR has never been fully tested and might only be capable of supplying half its declared amount of 4.4 million barrels/day for up to 90 days. Second, the U.S. might ask the Saudis to commit to ramping up oil production if U.S. differences with Iran intensify.

Third, the U.S. must work to minimize Iran's ability to reprise against its neighbors. We should work closely with Iraq to boost security of the southern Iraqi energy export facilities, by making it a priority and by employing infrastructure security experts and forces. We should work with other regional energy exports to augment the security of their energy as well.

Fourth, we should explore other means to export Persian Gulf oil by circumventing the Strait of Hormuz. For instance, we should press the Saudis and Iraqis to rejuvenate the old Iraq-Saudi pipeline to the Red Sea, which may eventually require some joint ownership of the line as well as rebuilding it on Iraqi territory. The United States should also work with Iraq and Turkey to refurbish and expand Iraq’s two pipelines through Turkey.

As a presidential candidate, Obama declared Iran’s nuclear development “unacceptable,” and as president he pledged “to use all elements of American power to prevent Iran from developing a nuclear weapon.” Toward this end, energy can offer some important levers, but the United States must be realistic about their impact and diligent in preparing for their use.

Ed Morse is head of research at Louis Capital Markets, and Michael Makovsky is Foreign Policy Director of the Bipartisan Policy Center and author recently of Churchill’s Promised Land (Yale University Press). Both were involved in the Bipartisan Policy Center’s recent report on U.S. policy toward Iran nuclear development, Meeting the Challenge.

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