UPDATE 1-Obama, G8 may remind Iran of their own "oil weapon"

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* G8 could say it's prepared to use oil reserves

* Iran oil exports have fallen by a fifth this year (Adds Hollande comment in para 5)

By Timothy Gardner and Jonathan Leff

WASHINGTON/NEW YORK, May 18 (Reuters) - Late last year, Iran issued a series of not-so veiled threats to the West, suggesting it could use its "oil weapon" to show displeasure over toughening sanctions by halting exports or disrupting the Strait of Hormuz.

This weekend, the Group of Eight nations may offer a timely retort: We've got an oil weapon of our own, and we're not afraid to use it.

After months of intense but quiet diplomacy with key allies, U.S. President Barack Obama may secure the support of the G8 to essentially pre-authorize a release of strategic reserves later this summer, just as U.S. and European sanctions on Iran come into force.

G8 leaders at this weekend's summit at Camp David in Maryland will discuss a "range of options" to address oil market strains, Tom Donilon, Obama's top security aide, told reporters. The Japanese news agency Kyodo reported on Wed nesday that Obama would urge leaders to support plans to release reserves. A diplomat said the topic will likely be part of an energy discussion on Saturday.

"My position is to use all instruments to lower (oil) prices," France's newly elected Socialist President Francois Hollande told reporters on Friday, confirming a shift in his stance since the elections.

"and European sanctions on Iran come into force.G8 leaders at this weekend's summit at Camp David in Maryland will discuss a "range of options" to address oil market strains, Tom Donilon, Obama's top security aide, told reporters"He said however that the question of reserves was not raised in his first meeting with Obama.

While leaders are likely to stop short of any hard and fast commitment to intervene in the oil market, the talks will show that this month's slump in oil prices hasn't deterred Obama from moving toward tapping the Strategic Petroleum Reserve (SPR) again - an unprecedented second release for a U.S. president.

U.S. crude oil has tumbled 12 percent this month, dropping to the lowest since before a November U.N. report on Iran's atomic program which kindled global fears.

Obama's focus on the SPR carries risks: Republicans will blast the White House for using a national security tool to buy votes; Saudi Arabia and other OPEC allies may cry foul for having their market-balancing role usurped; and some consumer nations, like Germany, have resisted suggestions of using stockpiles.

"Last year, the president released 30 million barrels of the reserve to manipulate oil prices and has yet to refill it. Releasing even more this year only lessens our buffer and protection when a true crisis hits," said Senator David Vitter, a Republican from Louisiana.

And it may do little to affect oil prices in the short-term: Analysts say many traders have priced in a likely release, and that right now, markets are well supplied.

But the message between the lines may ultimately be more important than the act itself, reinforcing a growing perception that Obama is leading a fundamental rethink of the strategic value of government crude.

A YEAR IN THE MAKING

It is a shift that began exactly a year ago, when the International Energy Agency's governing board issued a surprisingly blunt statement warning oil producers that it could use "all tools at its disposal" if they didn't increase output to offset Libya's war-torn exports.

A month later, in June 2011, the IEA announced a plan to release 60 million barrels, the biggest coordinated oil sale in its history.

This year's discussion would go further, using reserves as an affirmative policy tool rather than a supply of last resort, some analysts have suggested.

In the case of Iran, consumer nations could plan to preemptively fill any supply loss before it occurs, allowing them to amp up pressure on Tehran without inflicting further damage on their fragile economies.

"I think there is a debate globally on when and how to use strategic stocks, and there are lessons being learned in that regard, including whether a joint IEA approach is required," says Ed Morse, global head of commodities research at Citigroup and a former energy expert at the State Department.

Any war of "oil weapons" would be asymmetrical: The SPR would run out of oil within a year if it were forced to compensate for all of Iran's 2.2 million barrels per day of exports. But signaling a more liberal approach to the SPR will keep oil traders - and Iran - on edge.

Britain and France have indicated their support for releasing stocks, according to diplomats. Germany, the EU and the head of the IEA have voiced reservations, maintaining the strict interpretation that such reserves are to be used only in the event of a major supply disruption - for which no precise threshold has been set.

"I think it's fair to say that there is an ongoing reevaluation and it is likely to be accelerated if only because the SPR is becoming increasingly unusable," said Morse.

The unexpected surge in U.S. shale oil production in North Dakota and Texas is expected to dramatically reduce demand for imported sweet crude in the Gulf Coast, where the caverns holding the Strategic Petroleum Reserve are located. Almost half those caverns hold the same type of light, sweet crude.

NOT A FOREGONE CONCLUSION

The timing of this weekend's discussion is precise: World powers are due to hold a second round of nuclear talks with Tehran in Baghdad on May 23.

"A diplomat said the topic will likely be part of an energy discussion on Saturday."My position is to use all instruments to lower (oil) prices," France's newly elected Socialist President Francois Hollande told reporters on Friday, confirming a shift in his stance since the elections"The United States says Iran's nuclear program is a cover for developing the capability to build atomic bombs, while Iran says it is for civilian purposes.

"My guess is the G8 will come out with a statement that 'Should Iran be not be forthcoming, we are prepared to use the petroleum reserves that are at our disposal,'" said Guy Caruso, the former head of the Energy Information Administration (EIA).

That would not mean tapping the reserves is a foregone conclusion. It is unclear yet whether Obama and allies would opt to wait and see if Iran's exports fall and prices spike, or move preemptively to head off a speculative panic that could drive U.S. gasoline quickly above $4 a gallon.

ClearView Energy Partners says an SPR draw is "more likely than not" before July 1. Even if OPEC were to pump more crude, the SPR would not be off the table, they said in a recent research note.

"For a U.S. politician seeking reelection, getting crude from 'all of the above' may prove to be the most politically viable strategy," ClearView's Kevin Book said in the note, referring to Obama's domestic energy policy.

Iran's exports have fallen by more than a fifth since the start of the year as European nations abandon contracts and Asian importers cut back shipments.

And the shipments could be further curtailed in two ways.

Any country that wishes to continue buying Iranian crude without falling foul of sanctions must gain an exemption by June 28, six months since Obama signed tough new sanctions into law.

Only Japan and 10 European countries have so far won exemptions, although India this week said it would continue cutting back over time, without giving a target.

Even if Obama grants more waivers, as is widely expected, European sanctions that come into full effect on July 1 could bring exports to a swift halt by blocking access to the critical London-based tanker insurance market.

Britain is lobbying its fellow EU members for an up to six-month delay on those provisions, which would ban European Protection and Indemnity clubs from covering vessels carrying Iranian crude. Asian importers are lobbying for relief.

Until a decision is made to tap reserves, the price of oil could remain high.

"Markets at this point have discounted all the political talk," said Caruso. "The only thing that would move a market now would be an actual decision to tap reserves." (Additional reporting by Elizabeth Pineau, Editing by Bernadette Baum and Marguerita Choy)

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