COLUMN-EU pays price for oil sanctions on Iran: John Kemp

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By John Kemp

LONDON Feb 17 (Reuters) - Businesses and consumers across the EU are starting to pay a financial penalty for the bloc's decision to ban crude oil imports from Iran.

Near record prices for crude oil in sterling and euro are compounding the misery many firms and households were already suffering as a result of the region's debt crisis and faltering growth.

Even though the sanctions have not gone into effect fully, they are already contributing to a steep rise in fuel costs.

For supporters, sanctions were meant to be a low-cost way to increase the pressure on Iran's government without risking a sudden spike in oil prices that could derail the global economy.

Saudi Arabia and its close Gulf allies would be lined up to provide extra oil for Europe to make up for the loss of crude from Iran.

Meanwhile, buyers in China, India and other emerging markets would be quietly encouraged to continuing taking Iran's oil, perhaps in even bigger quantities than before, but use their newly enhanced bargaining power to secure big discounts, maybe even organise a buyer's cartel.

The result was supposed to be no change in the total volume of oil available to world markets but a big drop in revenues received by Iran's government. So long as markets responded "rationally" there would be little or no impact on oil prices and no cost to consumers.

Unfortunately, it has not worked out like that. Oil prices are now rising strongly in response to Iran's export problems as well as the loss of production from South Sudan, Yemen and Syria. While Saudi Arabia has increased its own production, the erosion of spare capacity has left the market jittery about further supply interruptions.

It seems likely prices will continue to escalate until a slowing economy restores a more comfortable cushion of spare capacity. Europe's businesses and households will pay at the pump and in what the Bank of England calls stronger "headwinds" for the economy.

THE SANCTIONS GAME PLAN

In an influential report on the "Oil Market Impact of Sanctions Against the Central Bank of Iran", which has circulated widely in Washington and European capitals, sanctions advocates Mark Dubowitz and Reuel Marc Gerecht of the Foundation for Defense of Democracies, promised "given adequate lead time, the oil market can adjust to most sanctions scenarios."

"It's possible to reduce Iranian oil revenue without reducing Iranian oil supply," they wrote.

The report presented detailed estimates of discounts for Iranian crude and the impact on government revenues depending on how many countries join the sanctions, whether other OPEC producers up their own output to compensate, and whether the remaining buyers for Iran's oil collude to extract significant discounts.

Dubowitz and Gerecht also estimated the impact on world oil prices, arguing they need not rise at all if the market responded "rationally" but could surge by as much as 40-50 percent if the market panicked or the Iranian government was plunged into crisis.

"Even if (sanctions) do not result in a physical oil market disruption, financial market reaction could drive up the price of oil.

"So long as markets responded "rationally" there would be little or no impact on oil prices and no cost to consumers.Unfortunately, it has not worked out like that"Eliciting commitments from other OPEC producers to offset any disruption in Iranian supply, giving Chinese firms a pass on compliance, and allowing other companies enough time to adjust would minimise the impact on oil prices and maximise the impact on Iranian revenue," wrote the authors.

"Making this game plan clear to financial and energy traders alike would reduce the risk of an alarmist market reaction".

OTHER SUPPLY INTERRUPTIONS

Dubowitz and Gerecht identified many of the factors that would influence the impact of sanctions on oil prices and Iran's revenues (including the extent of compliance, the response of OPEC, collusion among Iran's remaining customers, and the response of financial markets to actual and expected supply losses).

But they failed to assess adequately how far Iran would be able to find alternative markets for all the oil previously exported to the EU, Korea and Japan, particularly as other financial sanctions bite and countries encounter growing problems making payments for Iranian crude.

More importantly, they failed to assess how sanctions on Iran might interact with disruptions to other supply sources. There is an implicit "ceteris paribus" assumption running through the report. The authors assume other sources of supply and demand grow in line with expectations. They make no allowance for an unexpected pick-up in growth, or the sudden loss of production and exports from other countries.

This assumption has proved to be Achilles' heel of sanctions policy. Iran has struggled to redirect all its exports to developing countries in Asia because buyers are under pressure to comply with other restrictions on financial dealings with Iranian entities.

At the same time, production losses in South Sudan, Yemen and Syria have upped the call on Saudi and Iranian crude.

Saudi Arabia has stepped into the gap. But the smaller than normal build in oil stocks during January reported by the International Energy Agency (IEA) suggests it has struggled to offset the loss of other countries' exports and meet demand. It has also left the country with less than 2 million barrels per day of effective spare capacity.

The market is now just one major disruption away from running out of spare capacity, returning it to the exceptionally taut situation that prevailed in the first half of 2008. Prices will accordingly rise to slow the global economy and cut demand growth until a more comfortable level of inventories and capacity has been restored.

EUROPE MOST EXPOSED

Rising prices affect all oil-importing countries, but the impact has been most pronounced in Britain and the euro zone because of the weakness of their currencies.

In U.S. dollars, prices are still some way below the peak reached at the height of the last price crisis in July 2008.

"While Saudi Arabia has increased its own production, the erosion of spare capacity has left the market jittery about further supply interruptions.It seems likely prices will continue to escalate until a slowing economy restores a more comfortable cushion of spare capacity"Front-month U.S. crude futures are trading around $103 per barrel, while Brent is just under $120, both well short of the record over $140 set nearly four years ago.

But sterling oil prices are already well past their 2008 level and prices in euros are within 2 percent of their 2008 peak (Chart 1).

In contrast, Brent prices in China's yuan and Japan's yen are still 20 percent and 40 percent below their July 2008 peak respectively, owing to the strengthening of those currencies (Chart 2).

Rising crude prices have a smaller impact on the total cost of fuel paid by retail customers and businesses in the EU than elsewhere because Europe taxes energy much more heavily than Japan or the United States. Taxes accounted for 60-66 percent of the retail cost of a litre of fuel in the United Kingdom, France and Germany and Italy in 2010, according to OPEC, compared with 16 percent in the United States.

Excluding currency effects, rising crude prices therefore have a much bigger proportionate impact in the United States. But once currency effects are taken into account, it is customers in the EU that have been left facing record prices for gasoline, diesel and home heating fuel -- as well as higher prices for gas and electricity as a result of the partial link to crude prices in force across much of the region.

In a bitter irony, Europe's businesses and households are being hit hardest by the embargo EU foreign ministers imposed, in many cases overriding warnings about the possible impact from their own energy ministers and advisers. (Editing by William Hardy)

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