Since Iran sent missiles into Israeli territory last Tuesday night global oil markets have been focused on the risk of attacks on Iranian energy infrastructure. Oil prices rallied over $10 quite rapidly reversing previous sharp declines and commentators have a wide range of price forecasts. This note tries to summarize a few of the potential scenarios, impact on global markets and other factors. Overall, the price impact depends on how much, if any oil comes offline, and what the next response is after the next Israeli and or US response. US concerns about escalation and also perhaps higher oil prices, along with pressure from GCC states, have increased the chance of renewed sanctions enforcement. Overall though enforcement of sanctions is complicated by the creation of a partly decentralized illicit financial channel as little of the trade is conducted through G10 financial channels any more. The reluctance to hit Chinese end-buyers, given the range of issues in US-China relations, may also limit the impact of expanded sanctions.
Firstly, why price action now? Many people have been puzzled how conflict could escalate on so many fronts in the Middle East and have so little effect on oil markets. In my view, the markets were in “show me the outage” mode, waiting to see actual outages before price reaction. In part this reflects sluggish demand, especially from China which is both electrifying and facing weak industrial demand for oil products. This trend led to record surplus capacity as OPEC+ countries especially those in the GCC kept oil on the sidelines trying to manage prices. The significant capacity and continued supplies kept oil prices from rallying too much even when Ukrainian drone attacks helped to restrain Russian oil and product exports. The events of the last week are the first time in months that the risk of direct war between Iran and Israel and the risk (perhaps very limited) of impairment to GCC energy supply chains would limit the provision of that surplus capacity. While Libyan outages troubled the market for a time, the outage was offset by a view that other OPEC members would be delighted to pump more oil if given the chance.
The overlapping conflicts in the Middle East and reshaping of supply chains in Asia/Emerging World can create significant vulnerabilities quite extensively without necessarily attacking energy supplies. Moreover, the détente between Iran and Saudi Arabia which began following the Beijing Agreement has also been a major dampening effect on regional risk premia for oil. The agreement reduced the risk that Houthis or other Iranian partners would engage in drone attacks on GCC energy infrastructure. Remember Abiqaiq.
What might the impact of a destabilizing attack on Iran’s energy infrastructure?
In the aftermath of the missile attack, Israel began talking about making sure Iran experiences a major financial hit to deter future attacks. Relatedly key voices began talking about targeting Iran’s oil infrastructure with a physical or perhaps a cyber attack in ways that would hit their revenues and force them to invest in rebuilding, rather than support regional partners or its nuclear program thus deterring future attacks. The potential market impact would depend on the target chosen, the ability and willingness of other countries to replace supplies and the response from Iran and any potential collateral damage. In particular, would the next step be escalatory in ways that impair GCC energy capacity or willingness to produce. The latter is much more important to oil prices and stability than Iran production alone. While several factors reduce the risk that Iran itself would target GCC infrastructure, not least Iran’s hope that GCC countries would begin to invest in Iran’s economy, some of Iran’s export infrastructure is not far from that of GCC borders. Moreover a renewed risk of tankers being harassed and detained is possible, all of which could maintain a geopolitical risk premia.
Quickly commentators zoomed in on two major types of oil targets – domestic downstream infrastructure such as refineries and global export apparatus, especially that surrounding the dominant Kharg island. The domestic targets seemed the more likely choice – targeting them would lead to domestic shortages and possibly domestic instability, but would have less impact on global oil markets, given the relatively small volume compared to global supplies. Repair could require imports of parts and fuel for a period of time, both of which would be more costly and difficult due to sanctions. However, remember that Iran did add to its refined fuel capacity under extensive sanctions some time ago as it sought to reduce its vulnerability to fuel import sanctions and it might receive some help from friends. Some Iran watchers have suggested that cyber attacks might be more likely than physical kinetic attacks. Such attacks might be intermittent
As we have seen with Ukrainian attacks on Russian refineries, this might actually temporarily increase crude exports as refinery capacity is down, but Iran already struggles to meet domestic products demand. This could prompt Iran to go ahead with the nuclear weapons or to target Israeli energy infrastructure.
By contrast, hitting Kharg Island export capacity could knock out a portion of the 1.5 million barrel per day export capacity, a more meaningful share of global daily oil consumption and trade than Iran’s domestic demand. Still of course less than excess capacity held by Iran’s neighbors but a sufficient hit that would likely cause a more meaningful price increase and could prompt retaliatory measures. The US continues to be sensitive to oil price increases, especially in this electoral period but also worries about the ways that any hit might reduce regional security.
The biggest issue for the global oil market is whether the escalatory cycle in the region impairs even temporarily the ability of GCC countries (especially Saudi Arabia, Kuwait and UAE) from getting their oil to market. This would have a much more meaningful price impact and one that is hard to predict. Iran is unlikely to target GCC infrastructure despite threats on purpose. Its regional neighbors have recently extended a detente, but some actors in IRGC or the Houthis might try to harass tankers and engage in drone attacks which could lead to a more persistent geopolitical risk premia that has been absent. The ample surplus capacity in OPEC+ (mostly among GCC producers) and sluggish demand (especially China) has depressed prices of late, and this trend would continue if Israel targets non-energy targets such as the military sites that launched the missiles.
Sanctions A compromise? But will they be impactful? Given all of those risks, perhaps its no surprise that US efforts have turned towards offering more sanctions enforcement on Iranian energy flows. The USG has been negotiating with Israel about targets, seeking to deter direct hits on the nuclear program, which could be difficult to achieve or major energy infrastructure. We are hearing proposals for more sanctions enforcement that would aim to reduce volumes by several hundred thousand barrels per day in exports, and cut revenues further. This the US government believes would reduce available funds for regional partners, the military efforts but is a volume that could be made up by other suppliers, including some of those same OPEC countries which have surplus capacity.
However, there is a tradeoff. The development of the illicit financial network selling Iranian oil to China, its main buyer has gone underground and has many fewer US/G10 financial touch points. This means that tougher enforcement while not impossible, would require blunter sanctions than when Maximum pressure 1.0 was introduced in the Trump administration or in 2012 when oil output losses encouraged Iran to the negotiating table. Secondary sanctions on third countries helping to sell the oil would still likely be effective, but it remains to be seen if the US is willing to bear the costs of targeting the end-users in China that purchase Iranian fuel or even the infrastructure in the UAE and especially Malaysia that is key to the trade. Moreover, unlike in early 2010s or late 2010s, the network now uses an array of ship-to-ship transfers to complete the trade and buyers insist that they are not buying from Iran.
The US desire to avoid further escalation suggests they may target more vessels, such as a larger share of the dark fleet carrying Iranian supplies. Chinese buyers have proven wary of allowing actual sanctioned vessels into their ports although there has been some evidence of repainting and reflagging in the dark fleet. What seems most likely is an expansion of designated vessels. Until now, there has been a steady, almost monthly designation of tankers involved in the Iran trade (and the shell companies that own them), but only those whose carry Iranian fuel on behalf of regional partners like Hamas, Houthis and Hezbollah, a subset of overall trade. Might the US try to sanction a much greater proportion of the tankers? Would other tankers just move across from the Russia trade?
Notably, Congress passed new mandated sanctions earlier this year including the SHIP Act, which mandate that ports, shipping companies and other intermediaries be sanctioned. So far OFAC has yet to report to Congress on the implementation of these and related sanctions. There are signs that Treasury has engaged with some key intermediaries and urged more compliance, but some such as the Malaysians rebuffed them, suggesting that they only abided by multilateral (UN) sanctions. The 120 day report seems to be overdue but ought to be out soon. One other challenge with enforcement is that the laws focus on whether buyers and intermediaries knowingly engage in trade of Iranian fuel. Given that Chinese buyers insist they are buying from Malaysia or other intermediaries, there is a rather flimsy plausible deniability.
Enforcement of Iran sanctions and pressure on Iran may be a rising priority, as indeed Vice President Harris signalled in her recent 60 minutes interview, calling Iran a top adversary. However, the range of issues in the US-China relationship and other enforcement priorities including Russian illicit fuel trade, as well as choking off Russian dual use equipment, could get in the way. Thus, while oil markets may not be expecting sanctions yet, it seems likely that losses will be modest. The US may be banking on the OPEC+ commitment to reverse some of the many voluntary production cuts. Still, its worth remembering that the whackamole of enforcement has become more complicated as the trade has decentralized and the price cap has created a larger share of admittedly competing sanctioned players. Overall, if sanctions are the preferred tool, the impact on the oil markets might be limited.
Ziemba Insights 