Today’s report in the Wall Street Journal that the Obama administration is “encouraging key Arab states to boost oil exports to China to reduce Beijing’s reliance on Iranian energy” and thereby remove China’s resistance to a tougher stance towards Tehran’s nuclear program is a reminder that the Iranian nuclear issue remains among the top geopolitical risk factors that could impact the global oil market in the future.
While Saudi Arabia has been fairly conservative in its public statements recently on the Iranian situation and has avoided public declarations linking oil policy and its national security vis a vis the Iran issue, behind the scenes, Saudi Arabia has sent signals to Russia that the recent comfortable oil prices of around $70-$80 a barrel could quickly become a thing of the past, should Riyadh feel that a Russian-Iranian axis is too threatening to Saudi Arabia’s national security.
For now, it looks like a diplomatic solution to the Iranian situation is possible. However, if diplomacy breaks down and Saudi Arabia feels its interests are truly threatened, it has the same arsenal it has used in the past against the Soviet Union and Iran — including support from regional movements, militias or counterinsurgents and the ultimate trump card of an oil price war. The slump in global demand, combined with expansions of the kingdom’s oil fields, have left it with a large arsenal of spare oil production capacity and the ability to flood oil markets at will, perhaps together with the United Arab Emirates and Kuwait. Moreover, Riyadh’s foreign reserves to withstand a prolonged drop in oil prices are substantial, making it one of the largest creditor nations in the world. This time around, the Gulf Arab countries might combine increased oil exports with large new purchases of dollar holdings to ensure that paper oil futures markets track the fundamental weakening in physical oil markets, taking into consideration the kind of boost oil-dollar spread trading has given oil prices in recent weeks.
Iran’s pursuit of nuclear technology, if not checked by international agreements, hangs over regional stability. There is a precedent for deterioration in U.S.-Iranian relations to impact oil prices. U.S. initiatives to block Iran’s nuclear ambitions sent oil prices up by several dollars a barrel in the autumn of 2006. Iranian Supreme Leader Ayatollah Ali Khamenei in June 2006 warned the United States that Washington “should know that the slightest misbehavior on your part would endanger the entire region’s energy security…You are not capable of guaranteeing energy security in the region.” Saudi Arabia responded initially to this rhetoric by increasing its investments in upstream oil production capability in order to be able to replace any lost Iranian exports. Because of its regional leadership role, its position as the guardian of the holy sites of Medina and Mecca, its close ties to Iraq and Lebanon, and its large Shi’a population, Saudi Arabia has a strategic interest in reining in Tehran. More recently, Arab commentators have blamed Iran for fomenting recent fighting between Shiite rebels and the Yemenese government.
Iran’s test firing of missiles the week ahead of Iran’s meeting with Western governments in September regarding Tehran’s nuclear program caused apprehension in the Arab nations of the Persian Gulf. The situation has caused some commentators in the region to openly espouse a more overt alliance with Israel, potentially signaling to Tehran that the Arab world would not condemn an Israeli attack on Iranian nuclear facilities and may even grant Israel the airspace to do so. In an op-ed in the pan-Arab newspaper Al Quds al Arabi, an editorial stated, “the Arab regimes, and the gulf ones in particular, will find themselves part of a new alliance against Iran alongside Israel.” Other Gulf commentators have even suggested that an Israeli military strike is the best policy option, rather than just allowing Iran to emerge as a nuclear power. This kind of public rhetoric is unheard of previously in the Arab world and represents a strong departure from the past when coordination with Israel has been considered but kept secret from the Arab public.
The threat that Israel would indeed take military action against Iran to slow down its nuclear program is the largest risk factor for oil markets when it comes to the Iranian situation. In the past, Israeli officials have warned that Israel could hit vulnerable oil export facilities like Kharg Island and other offshore regions instead of or in addition to preemptively attacking the Bushehr nuclear plant. An attack on Iran’s sole oil export facility would put the Iranian government under tremendous pressure because the country is already so financially strapped. Kharg Island is a possibly attractive option since it is unclear if Israel would have the capability to knock out all of Iran’s nuclear facilities. If Iran felt its own oil export capability was about to be or had been destroyed, it might counter by issuing a threat to damage oil facilities or block exports from other nearby U.S.-allied countries such as the Persian Gulf oil producers. And, of course, any escalation in military action in the region would immediately bring tremendous oil price volatility back to markets, even if Saudi Arabia increased production to replace Iranian exports lost in a military exchange with Israel.
It remains to be seen how the Iranian negotiations with the West will play out over the next six months, but progress in the diplomacy between the West, Russia and Iran will have great bearing on the geopolitics of oil — one way or the other. A significant agreement between Iran to end its enrichment program would take one major geopolitical risk factor away from oil markets, promoting a more stable price environment and a relatively stable price. But if current diplomacy fails, we could see again the same kind of giant swings in oil prices of 2007-2008.
Amy Myers Jaffe is the Baker Institute Wallace S. Wilson Fellow in Energy Studies and director of the Energy Forum.