The United States has got a tiger by the tail as it ratchets up the pressure on Iran over its nuclear program while attempting to avoid an oil-price shock that would seriously damage the fragile global economy.
Iran has responded to the U.S. move to tighten sanctions by threatening to close the strategically crucial Strait of Hormuz, a key gateway from the Persian Gulf through which much of the world's oil trade passes.
The rising political tensions roiled the global crude markets on Tuesday, as the benchmark North American oil price jumped more than $4 (U.S.) a barrel crude to $102.96. Traders are betting that prices would spike dramatically – perhaps as high as $150 (U.S.) a barrel – if the standoff escalates into an actual military conflict.
Higher crude costs would reduce household spending on others goods and services; drive up other prices, especially food, and batter the confidence of long-suffering consumers.
U.S. President Barack Obama signed into law on New Year's Eve a series of new sanctions that would prohibit any foreign bank or institution that continues to do transactions with the Iranian central bank from having access to the U.S. financial system. The sanctions – which Mr. Obama can apply selectively – hit directly at Iran's weakened financial state and its ability to sell oil on the international market.
The European Union is scheduled to debate tougher sanctions later this month, including similar financial measures to those taken by the United States, and an embargo on importing Iranian oil.
In response, Iranian military officials have warned that the country will close the Straits of Hormuz, and have backed up that threat with a series of missile tests and naval manoeuvres that ended Tuesday.
While the Obama administration is attempting to squeeze the Iranian regime into backing off its nuclear-development program, U.S. officials sought to play down the possibility of military conflict in the Persian Gulf.
"No one in this government seeks confrontation over the Strait of Hormuz," Pentagon spokesman George Little said Tuesday. "It's important to lower the temperature."
17 million barrels a day
The Strait of Hormuz – a mere 34 kilometres wide at its narrowest spot – is the world's most critical choke point for crude-oil trade.
Every day, some 17 million barrels of crude is expected through the waterway from Saudi Arabia, Iraq, Kuwait, the United Arab Emirates and Iran itself. That represents 35 per cent of the world's seaborne crude export, and almost 20 per cent of total oil traded.
In recent days, Iran has test-fired both medium- and long-range missiles in the area, and its senior military officials have been blunt about the country's determination to respond to the West's financial stranglehold with its own economically targeted attack – a closing of the oil shipping route.
Alternate routes do exist to get crude out of the region – including underutilized pipelines through Iraq, Saudi Arabia and the United Arab Emirates.
While many analysts doubt the ability of Iran to close the straits given the dominating presence of the U.S. Navy, Tehran's threat is not being dismissed out of hand.
"A ship on the ocean is an obvious target," said Michael Lynch, president of Strategic Energy & Economic Research. "Even the Iranians can hit one."
It's likely not in Iran's interest to close the Persian Gulf to oil exports since it would be hurting customers such as China and India and depriving itself of export revenues, said Bhushan Bahree, Washington-based Middle East expert with IHS CERA consultancy.
"But they can certainly make everybody think this is a dangerous situation," Mr. Bahree said. "They could harass shipping; make it more expensive to insure; discourage ship owners from sending ships in and continuously keep the level of tension up."
Political tensions in the Middle East actually help oil exporters, and Iran's sabre-rattling is driving up the price of its chief export, crude oil.
Mr. Bahree has calculated the Persian Gulf state saw its oil revenues soar to $100-billion (U.S.) in 2011, up more than 30 per cent from 2010 thanks to elevated crude prices.
While a strengthening global economy helped lift oil prices last year, they were also driven higher by upheaval in the Middle East, including the Libyan revolution and the broader turmoil of the Arab Spring.
The Libyan uprising took some 2.6-million barrels per day of production off global markets, while the threat of spreading upheaval drove up the premium that gets embedded in oil prices when traders fear further political risk.
As Iran repeatedly failed to co-operate with the International Atomic Energy Agency, which sought to inspect its nuclear operations, the Western allies have imposed increasingly tough sanctions against exports to, or imports from, Iran.
As a result, Tehran is having difficulty keeping up its oil production because U.S., EU and Canadian sanctions have blocked much-needed foreign investment and made it difficult for the Iranians to obtain the parts and technical services needed to maintain their oil fields.
Because of U.S. and EU financial sanctions, Western banks no longer issue letters of credit to foreign companies wanting to do business in Iran, making it increasingly difficult and expensive to conduct trade.
"They do benefit from rising oil prices but if stricter sanctions are to fall in place from the EU, they would have to find other buyers for their oil and clearly they would not benefit from that," said Matthew Jurecky, director of energy research at Global Data Inc. in New York.
Already, Chinese buyers are reportedly cutting their demand for Iranian oil and will insist on deep price discounts if Tehran's other customers adopt the embargo.
450,000 barrels a day to the fragile EU
Despite imposing sanctions of broader trade with Tehran, the European Union remains one of Iran's largest oil customers, with the lion's share of the 450,000 barrels per day of crude imports going to Greece, Italy and Spain.
Those southern European countries are already coping with a debt crisis that has hammered their economies, and they can ill afford an oil embargo that will drive up the price of crude imports.
Officials in Tehran appear to believe that the U.S. and EU will back off their most draconian sanctions in order to ensure that Iranian oil continues to flow into international markets.
A senior Iranian official told Reuters last month that an EU embargo would rebound onto Greece, Italy and Spain, and "they have the most fragile markets." He added that EU sanctions would cause an "energy crisis" in those countries.
In the event of a boycott, the southern European countries would be hard-pressed to replace the lighter grade Iranian oil, which is needed for their refineries.
The United States believes that Saudi Arabia will maintain whatever production is needed to make up for the shortfall in Iranian oil, should the sanctions succeed in reducing its overall exports, as oppose to simply diverting them to other markets. But Saudi Arabian crude is often a heavier grade that European refineries can't handle.
One bright spot is the rapid growth in Libyan production from the near-shutdown of production during last year's civil war. Libya was also a major supplier to Mediterranean Europe.
Libyan government officials said the country was producing one million barrels per day at the end of the year, and expects to reach prewar capacity of 2.6 million barrels by the middle of this year.
40-per-cent loss to Iranian currency
Iran is already facing financial and economic problems and the existing sanctions have clearly added to the inflation and economic malaise that it causing trouble for the ruling regime.
Iran's currency, the rial, is in freefall, having lost 10 per cent of its value against the U.S. dollar in the past week and 40 per cent in the past year.
Iranian officials claim the currency's plight is unrelated to the new sanctions, noting they have yet to take effect. But analysts say Iranians are anticipating further economic hardship, and the rial's decline reflects that pessimism.
"The cost of the sanctions is adding up and the difficulty is adding up and because the economy is already under a lot of pressure, it will definitely add to it," said Vali Nasr, a senior fellow with the Brookings Institution and a former State Department official.
Mr. Nasr said the aggressive tone of the Iranian response to the latest round of sanctions is clear evidence of the economic impact they will have on the country, which is facing a parliamentary election in March.
Iranians had been supporting the rial at elevated levels, in part of keep inflation in check. (The price of imports climbs when a currency is devalued.) But Tehran no longer has the capacity to support the rial, Mr. Nasr said. At the same time, sanctions have led to a flight of capital that drives down the rial further.
The country is also pursuing a series of economic reforms to reduce state intervention in the economy, including the end of gasoline subsidies. As a result, inflation is raging and the devalued currency is adding to the problem.
$150 a barrel
Crude oil prices shot higher Tuesday, due in part of the sabre-rattling over the Strait of Hormuz. How high they go depends on whether the crisis is contained or whether Iran makes good on its threat to fire on shipping in the Strait of Hormuz, prompting a military response from the United States.
Already, oil-market traders are laying bets in financial markets that prices could hit $150 (U.S.) a barrel, topping the high-water mark of $147 (U.S.) hit during the bubble of 2008, just before the economy crashed.
That's an extreme case and would be the result of a shooting war – however brief – around the Strait of Hormuz that would stop tanker traffic.
An effective boycott of Iranian oil, coupled with fears of an escalating crisis, could drive North American crude prices as much as 20-per-cent higher – back above $120 (U.S.) a barrel where they peaked last spring during the Libyan crisis. International prices could touch $130 (U.S.) a barrel.
And that would be bad news for the North American economy. And indeed for the world … unless you are an oil exporter.
The International Monetary Fund estimates that even a 10-per-cent increase in the prices of crude sustained over several months could knock nearly half a percentage point off U.S. growth.
"If we get $120, or $130 oil all over again, we face the risk of much softer consumer numbers and the possibility of a retrenchment in U.S. consumption as they spend more on what they have to and less on what they don't," said Derek Holt, a vice-president and economist at the Bank of Nova Scotia.
Despite its position as a net exporter of crude, Canada may not fare much better, given the economic pressure that households face, with record debt levels, stagnant wage growth and pockets of high unemployment.