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Sunday, January 29, 2006

OPI WEEKLY: DELAY TACTIC DIPLOMACY AND IDLE OIL THREATS: IRAN'S NUCLEAR ASPIRATIONS AND THE WEST

Iran’s confrontation with the West over uranium enrichment is once again coming to a head. The International Atomic Energy Agency (IAEA) is set to meet next week to consider referral of Iran to the United Nations Security Council for possible sanctions, and a majority of the 35 member board has already signaled its intention to refer Iran’s case to the U.N. While sanctions are by no means a certainty –thanks largely to the uncertain stance of China on the matter—they are for the first time in the Iran crisis a real possibility. In preparation for possible U.N. action, Iran has reportedly transferred its European denominated assets to less ethically finicky countries and has threatened to cut oil supplies in response. What happens next will depend on Iran’s ability to once again wield its most effective weapon so far in the standoff over its nuclear intentions: time.

DELAY TACTIC DIMPLOMACY

In an attempt to forestall IAEA action or, failing that, Security Council sanctions, Iran has signaled its qualified support for a proposal to have its uranium enriched on Russian soil and then shipped to Iran for use in the generation of electricity. Russia and China immediately voiced their support for the plan, and the United States has also accepted the proposal in principal.

It is highly unlikely, however, that anything but delay will ever come of the plan. Once the U.S. agreed to the scheme, Iran took a step back, saying that in order for it to agree to Russian enrichment, “other countries” would have to be involved. Nothing stalls international agreements more effectively than adding more countries to the mix.

Iran’s tried and true best friend in its years-long effort to gain a nuclear weapon has been time, and delay tactics may well continue to work in forestalling U.N. action. The permanent members of the Security Council –Britain, France, Russia, China, and the U.S. whose agreement would be necessary to pass a sanctions resolution, have a diverse array of interests at stake when it comes to Iran.

Tehran was exceedingly successful at dragging out its negotiations with the EU-3 (Britain, France, and Germany). The talks commenced in the late summer of 2003 and followed the familiar pattern with Iran of near compromise followed by Iranian defiance, followed by Iran calling for talks to continue. The EU-3 played along hopefully for over two years before finally throwing in the towel on the exercise late last year. France in particular was hoping to broker a successful compromise with Iran in order to show itself as a capable geopolitical arbiter. However, when those talks came to nil, Britain and France were left with no other option than to express their support for referral of Iran to the U.N.

While Russia has more sympathy –and business—with Iran than the West –indeed, they are helping Iran to build out its “peaceful” nuclear technology—a nuclear weapons capable Iran poses problems for Russia. A nuclear Iran could wield greater influence among the restive Islamic populations in Russia’s Caucasus region, already a thorn in Russia’s side. Combined with its hesitation to oppose the U.S. and Europe on an issue of such importance to the West, Russia may well cooperate with Britain and France if the issue makes it to the Security Council.

That leaves China. China sits between a rock and a hard place on the Iran question. It is currently walking a political and economic tightrope at home as it tries to reform its badly dysfunctional economy. Protests and public disturbances have become increasingly common as the result of the hardships that come along with economic reforms. A further blow to its economy caused by U.N. imposed sanctions on Iran would exacerbate an already critical situation. While China imports only 12 percent of its crude oil from Iran, it has significant current and pending energy development projects in the country. In addition, the impact of increased oil prices that would result if Iran made good on its threat to pull its oil off the market, would hit China’s economy hard.

On the other hand, China would not welcome the diplomatic consequences of opposing the West, particularly the U.S., on the Security Council. In a clear shift from the early days of the Bush presidency, the U.S. and China have recently initiated a “Strategic Dialogue” to deal with issues such as trade, Taiwan, and North Korea. A Chinese veto of Iran sanctions on the Security Council would bring this warming trend to a screeching halt. The U.S. Congress, not to mention the Bush administration, would no doubt react strongly and swiftly to an Iranian veto. Issues near and dear to Chinese economic reform, such as the overvaluation of the Yuan and open export markets abroad, would once again become front and center in U.S. legislative politics. A Senate proposal to impose a 27.5 percent across-the-board tariff on Chinese imports would certainly gain renewed support.

So what will China do? They will likely try to do what any rational country does when stuck between a rock and a hard place: nothing. Fortunately for Iran, this is exactly what it wants. China will push hard for more time on the Russian plan, while promising the U.S. that if it waits to see if the Russian plan works before bringing a resolution to the Security Council, China will support sanctions at that time. If China is able to convince Russia to take the same line, the likelihood of the U.S. pushing for a vote decrease even further.

IRAN’S IDLE OIL THREAT

If somehow the U.S. were able to convince China and Russia to vote its way in the Security Council, Iran’s options would be few. While creating hardship for a world economy already laboring under high oil prices, an Iranian curtailment of oil exports would hurt Iran much more than the world it supplies. Iran is the world’s fourth largest crude producer and exporter with 4.2 million barrels per day in production and 2.7 million barrels per day in exports. Almost 90 percent of Iran's total export earnings and about 50 percent of the government budget come from oil exports alone.

At the current OPEC price basket rate of $60 per barrel, Iran would lose $162,000,000 per day or $59.1 billion per year –a full 30% of its GDP—if it withheld all its supplies. Iranian budget deficits, already bloated in part due to large-scale state subsidies on gasoline and foodstuffs, would balloon. Even if Iran continued to sell a portion of its oil on the market, the effects on its economy would be profound. Furthermore, the more oil it continued to sell, the less effect the curtailment would have on oil prices, dampening the political effectiveness of the move and making more difficult for Iran to make up the revenue shortfall. As if that weren’t bad enough, Iran imports a third of its gasoline because of a lack of refining capacity at home. Increased oil prices would hit Iran along with the rest of the world as the price of refined petroleum products increased along with the price of oil.

Iran’s domestic situation would be hard-pressed to handle the economic blow that would ensue from an oil curtailment. With unemployment in Iran already averaging around 14 percent and significantly higher among young people, the social and political effects of an economic crunch could be extreme. Two bombings in the southwestern Iranian city of Ahvaz last week on the day that Iranian President Mahmoud Ahmadinejad was due to visit underscore the fact that Iran’s leadership has no shortage of enemies at home. Ahmadinejad’s motorcade also came under attack recently as it made its way on the Zabol-Saravan highway in the country’s southeastern provinces of Sistan and Balochistan. The economic collapse and social dislocation that would undoubtedly result from an oil embargo would give Iran’s internal enemies ample opportunity to challenge the ruling regime.

As for the rest of the world, a decrease in Iranian supplies, while not easy to swallow, would be far from catastrophic. With no love lost for Iran, Saudi Arabia would bring its 1.5 million barrels per day of spare capacity on line. This would fully cover an Iran supply cutback of over 50 percent, effectively muting the intended price increase. If Iran withheld all its oil, prices would likely jump to over $90 per barrel at the outset. However, in addition to Saudi oil, the U.S. and Europe could tap their combined 1.3 billion barrels of strategic petroleum reserves. Those reserves alone could replace the shortfall after Saudi capacity is maxed out for nearly three years. Even if Iran’s economy and political stability could hold out that long –which seems exceedingly unlikely—32 months is long enough for new production to come online in the Middle East, Russia, and elsewhere.

No matter how one slices it, a curtailment of oil supplies is a losing proposition for Iran. Conversely, U.N. sanctions which included an embargo on Iranian oil could be quite effective, although it is unlikely that even if the U.S. were successful in a Security Council vote that sanctions would go that far. For precisely this reason, Iran will work hard at the delay tactics with which it has been so successful in the past.

CONCLUSION

Given the array of interests involved in the Iran question, the chances of a vote soon at the Security Council seems unlikely, and the chances of a unanimous vote for sanctions even dimmer. The more realistic question is how long the U.S. and Israel will suffer Iran’s delay tactics before deciding on a military strike on Iranian nuclear sites. As is so often the case in international affairs, the unilateral use of force may turn out to be the easier softer way in comparison to the complications inherent to multilateral diplomacy.

5 Comments:

At 7:26 PM, Blogger David Amulet said...

Two thoughts:

(1) You refer to iran shifting currency to countries less "ethically finicky" than Europe. That made me laugh, seeing as you point out Europe has been negotiating with Iran for years! It's a sad day when France is the ethical standard for the world!

(2) You say that a decrease in Iranian supplies would not affect the rest of the world much because Saudi Arabia could boost production, "effectively muting the intended price increase." But aren't price spikes--even dramatic ones--caused by the psychological effects of world events than actual supply numbers?

I look forward to your comments!

-- david

 
At 9:51 AM, Blogger David Amulet said...

But on the other hand, I do worry about refining capacity here. Even if the Saudis (and/or others) step up production right away, is the supposed "refining bottleneck" still a factor that will have prices going up if there is a shock to the system?

-- david

 
At 12:28 PM, Blogger David W. Martin said...

Thanks, David, for your comments! On(1)yes, sad indeed. France also has a major gas development project going in Iran. It wouldn't surprise me one bit if they insisted as a condition of their support at the U.N. that economic sanctions which include an investment embargo exclude existing projects. With friends like that . . .

On (2), you are absolutely right that psychology plays a huge part in the price of oil, especially now that the only spare capacity is in Saudi Arabia. However, most analysts agree that market fundamentals themselves do not explain current prices at over $60-$68 per barrel; that is, a large psychological component is already built in to the current price. An Iranian cutback would still add to that "security premium", but the effect would not be as dramatic as one might otherwise expect. The EIA suggests a rule of thumb of adding $5 to $7 per barrel for each million barrels of supply disruption. By that calculation, if Iran pulled the entirety if its production off the market one might expect a price jump from the current $68 (the highest priced benchmark crude) to $87 per barrel. Once Saudi crude came online, one could expect the price to drop to about $76 per barrel. My own sense is that prices are "sticky upward", meaning that price decreases don't respond as quickly to changes in market fundamentals as price increases --for purely psychological reasons. One might thus expect prices to settle around $80 or even $85 per barrel until additional oil was brought online (especially because Saudi spare capacity is of the "sour" (high sulfer) variety which generally pulls a lower price). While $85 per barrel is pretty high, the effect would be far from catastrophic. U.S. GDP growth tends to decrease by .05% to .1% per 10% incease in the price of oil. So, at $85 oil, we cold expect a .1 to .2 percent drop in GDP for a quarter or two, depending on how long it took for Saudi oil to soften the price. Other countries would likely be hit harder, depending on the oil dependence of their economies. Not a sterling situation, but hardly the catastrophic outcome that some describe.

 
At 12:46 PM, Anonymous Simon said...

Nice to see OPI back again after a long break.

I strongly believe that military action against Iran is unlikely, and that Iran will acquire a full nuclear fuel cycle within ten years.

While Israelis and Americans alike say that military action is still on the table, neither will carry out military action unless they believe that they have a good chance of success i.e. setting back the program by a number of years, if not permanently. They must also be confident that they can 'manage' any Iranian military retaliation for such an attack.

It is not clear that either Israel or America will be able to destroy the majority of sites associated with the program through military action. Nor is it clear that the US or Israel are willing to risk retaliation from Lebanon or in Iraq.

In international relations, as in life, there are often problems with no realistic solutions. Iran's nuclear program is one such. Military action seems unrealistic; economic sanctions are unlikely to bite hard (Iran has already survived an 8-year wartime embargo, and a decade of US sanctions. It still manages to generate oil revenues despite the decline in its oil industry, and has effectively avoided the embargo through smuggling).

Try to delay the program by all means; but the world should accept that Iran will eventually get what it wants.

 
At 6:50 PM, Blogger David W. Martin said...

Thanks for your comments and your kind words. Your point about the consequence of a military strike on the situation in Iraq is particularly interesting. The U.S. is in an extremely delecate -and by now somewhat desperate- situation in Iraq and any move that significantly decreases its chances of success there is unlikely to be undertaken. The U.S., no doubt, will be much better able to confront Iran when (and if) Iraq is stable. Without a stable Iraq, the U.S.'s lattitude in the region is severely circumscribed.

 

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