If the Iranian government makes good on its recent threats to stop oil shipments through the Strait of Hormuz, oil prices would shoot up $20 to $30 a barrel within hours and the price of gasoline in the United States would rise by $1 a gallon.
Such a steep spike in crude oil prices would plunge the United States and Europe back into recession, said Money Morning Global Energy Strategist Dr. Kent Moors.
Iran just concluded a 10-day military exercise intended to prove to the West that it can choke off the flow of Persian Gulf oil whenever it wants.
The world's fourth-biggest oil producer is unhappy with fresh U.S. financial sanctions that will make it harder to sell its oil, which accounts for half of the government's revenue.
"Tehran is making a renewed political point here. The message is – we can close this anytime we want to," said Moors, who has studied Iran for more than a decade. "The oil markets are essentially ignoring the likelihood at the moment, but any increase in tensions will increase risk assessment and thereby pricing."
One reason the markets haven't reacted much to Iran's latest rhetoric is that although it has threatened to close the Strait of Hormuz many times over the past 20 years, it has never followed through on the threat.
But a fresh wave of Western sanctions could hurt Iran's economy enough to make Tehran much less cautious.
The latest sanctions, signed into law by U.S. President Barack Obama on Saturday, will make it far more difficult for refiners to buy crude oil from Iran. And looming on the horizon is further action by the European Union (EU), which next month will consider an embargo of Iranian oil.
"The present United Nations, U.S. and EU sanctions have already had a significant toll," said Moors. "They have effectively prevented Iranian access to main international banking networks. Iran now has to use inefficient exchange mechanisms."
Because international oil trade is conducted in U.S. dollars, Moors said, Iran must have a convenient way to convert U.S. dollars into its home currency or other currencies it needs, such as euros.
Pushed to the Brink
The impact of the sanctions combined with internal political instability has driven Iran to turn up the volume on its rhetoric.
"Tehran has limited options remaining," Moors said, noting Iran has historically used verbal attacks on the West to distract its population from the country's problems. "The Iranian economy is seriously weakening, the political division among the ayatollahs is increasing, and unrest is rising."
Analysts worry an Iranian government that feels cornered would be more prone to dangerous risk-taking in its dealings with the West. So while totally shutting down the Strait of Hormuz isn't likely, Iran could still escalate a confrontation beyond mere talk.
For instance, although Iran's naval assets in the Gulf are no match for the U.S. Fifth Fleet based Bahrain, its small subs and mining capabilities could severely disrupt merchant traffic in the Strait, through which 18% of the world's oil travels.
And if Iran can do enough to convince the world that it's serious, it could scare the markets enough to cause crude oil prices to jump and insurance premiums to rise. That would punish the West without harming Iran's economy.
"Even if Iran does not actually close the Strait, a continuing naval presence in its own territorial waters would put pressure on the traffic," Moors said.
[Note: Along with serving as Money Morning's Global Energy Strategist, Moors also advises governments and companies worldwide. He shares his expertise and ideas for how to profit in the energy sector in such publications as Oil and Energy Investor, Energy Advantage, The Energy Inner Circleand the new market-breaking Energy Sigma Trader.]
In a worst-case scenario, a desperate Iranian government would try to achieve its aims by arming proxies such as al-Qaeda or Hezbollah to launch attacks on shipping going through the Strait.
That sort of major threat could push oil toward $200 a barrel, which would translate to U.S. gasoline prices of $6.50 a gallon.
Fortunately for the West, Moors said Iran has other factors restraining it from choking off the flow of oil out of the Persian Gulf aside from the presence of the U.S. Fifth Fleet.
For one thing, Iran needs Western technology to help boost its fields with declining production; Chinese and Russian alternatives aren't as effective.
Another problem is very poor domestic refining capabilities, which means Iran must import gasoline and low-sulfur heating oil.
"The overall demand cannot be met by domestic production," Moors explained. "But even with the portion that can, the products need to be mixed with higher grade imports to avoid serious problems – including explosions."
And finally, any actions Iran takes in the Strait of Hormuz to restrict shipping would hurt its own ability to import much-needed food and consumer goods.
"Iran is as reliant, if not more reliant, on the Strait of Hormuz than any other country," Ali Nader of the RAND Corp. research institute told Bloomberg News.
Nevetheless, the situation remains volatile, and the threat to global oil markets is real.
"This increase in Iranian [military] capability is almost certainly not designed to take the form of a major war with the U.S. and southern Gulf states," wrote Anthony H. Cordesman in a Center for Strategic & International Studies report last month. "It does, however, give Iran the ability to carry out a wide range of much lower level attacks which could sharply raise the risk to Gulf shipping, and either reduce tanker traffic and shipping or sharply raise the insurance cost of such ship movements and put a different kind of pressure on the other Gulf states and world oil prices."
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