Has President Obama walled off the U.S. economy from a boomerang impact from stringent new oil sanctions against Iran? He suggests he has through a furiously negotiated web of agreements with allies and especially Saudi Arabia: In a pinch, the world's developed economies will release coordinated volumes of oil from their strategic petroleum reserves, and Saudi Arabia will step up production so that the flow is steady.
It is a system designed to perfection. Which may be the problem.
In three months, the new Western-led sanctions take effect to starve Iran of oil profits, and persuade it to halt its presumed development of nuclear weapons. The idea is that Iran will manage to sell less of its current 2.2 million barrels a day of oil exports, and what it does manage to unload will have to go at a steep discount. Being hurt in the wallet, and worried about the potential political fallout, the Iranians will abruptly compromise at the negotiating table (the next round starting April 13 in Istanbul).
Specifically, the Europeans are more or less halting purchases of Iranian oil by July 1; the U.S., in turn, is threatening penalties as of June 28 against any financial institution from any country that does business with Iran's central bank. But Obama and the Europeans want to make Iran the victim, and not Western motorists, and so have expended much effort to make sure there is plenty of non-Iranian oil available. On Friday, Obama said that, while he will keep monitoring the situation, the effort has succeeded.
The plans seem aimed at responding to any Black Swan event, the type of unforeseen calamities to which we have become accustomed the last five or so years -- among them, hurricanes, spontaneous popular uprisings, financial catastrophe.
These are precisely the events that keep oil traders employed. The trading pivot is spare production capacity -- the volume of extra oil that producers can pump and send to market should there be an emergency someplace. As of now, the world has an estimated 2.5 million barrels a day of spare capacity, almost all of it in Saudi Arabia, against daily global demand of about 89 million barrels a day. When a Black Swan erupts, traders bet against the ability of this spare capacity to respond sufficiently. That is when prices go up.
The thing is, though the western-led plans seem aimed at moderating such outcomes, they seem to leave almost no latitude for contingencies (pictured above, Filipinos agitated over price increases today). This is no fault of their own, mind you -- at the moment, there simply is very little spare capacity, and no plans by companies to create any for a few more years.
Consider the current situation: Iranian oil goes off the market, and millions of barrels of oil marshaled by the West and Saudi Arabia compensate for it. At once, spare capacity, now shrunk since some has gone into production, is halved to, say, 1.5 million barrels a day.
Traders go into action. One day, they bid prices up on a pipeline explosion in Nigeria, the kidnapping of an Israeli diplomat in Bangkok, or the rumor of the impending Iranian mining of the Strait of Hormuz. The next day or so, they bid the price back down when there is no impact on oil supply.
And so on and so on. The traders, acting on the very real situation of supply tightness, earn money each time the price moves, as long as they are on the right side of the bet.
As Citigroup's Ed Morse said it succinctly in an email exchange, "There's not much [oil supply] left for a disruption beyond an Iranian one."
I emailed Greg Priddy, who watches the Middle East for Eurasia Group, the political risk firm. The U.S. has done well to negotiate lower Iranian oil imports from countries like Japan, he said, but a structure problem remains. Priddy said:
This could lead to a market which is adequately supplied, but with spare capacity so thin that prices start being bid up toward a level of serious demand destruction, similar to how the market reacted in the first half of 2008. The U.S., by agreeing to grant waivers to Asian allies like Japan based on reductions of imports of only 20 percent, has calibrated the volume of probable 'displaced' barrels down to below 1 million barrels per day. But, if one assumes that those volumes don't find buyers elsewhere, and that after any possible summer Strategic Petroleum Reserve release, Saudi Arabia makes up that volume, that leaves (Saudi claimed) spare capacity down to around 1.5 million barrels per day. The market has serious doubts about the true extent of Saudi spare capacity, and I think at a level of 1.5 million barrels per day or below you would see some serious price upside. SPR releases can't make up that sort of volume for very long without getting down to dangerously low levels, so I don't think we'll see a continuous release of more than two months duration.
Priddy sees light, however. He thinks that the market could be saved by Iran itself, needing the money so relenting and selling at a discount, which at least publicly it so far has refused to do. Priddy:
I don't think we will ultimately get to the 'thin spare capacity' scenario, largely because I think Iran will eventually be forced to discount its crude, and that at least some of it will find buyers elsewhere. ... We won't know the answer to that probably until mid-summer, when the full displacement from the EU takes place and the Iranian's can't continue to store it (as they're doing now already with 4 tankers parked at Kharg Island).
Yet it is this uncertainty that feeds oil trading. We may be headed into a season of greater oil volatility.
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