As Squeeze Tightens on Iran, Fuel Prices—for Now—Reflect Calm

Iran faces mounting pressure over its nuclear program at a time of bountiful oil supply and weak demand. But how long can low gas prices last?

Motorists in the United States and Europe can be forgiven if they didn't notice that their nations' long-planned oil embargo against Iran took full effect this month. As the West ramped up pressure on the Islamic Republic over its nuclear program, summer drivers on both sides of the Atlantic have been able to tank up on fuel at its lowest price since early January.

The question is whether that ebb will last, now that the flow of oil has been choked from ports of the world's third-largest crude exporter, the nation that provided 5 percent of the world's liquid-fuel supply last year. Global crude oil prices rose slightly after Iran renewed its threat to retaliate by blockading the Strait of Hormuz. But news of the continued weakness in the global economy—most notably, an anemic U.S. jobs report—kept the price increase in check.

(Interactive Map: Strait of Hormuz: The World's Key Oil Choke Point)

The relative oil market calm lends support to the view of many energy analysts: The squeeze on Iran, from the point of oil-consuming nations, couldn't have happened at a better time. Demand is sagging, not only due to cyclical economic woes, but also because of what an increasing number of experts see as a historic and long-term downturn in gas guzzling in the most developed nations. Just as important is the other side of the equation: The world is awash in oil. From the rebuilt fields of Iraq, from the revived petroleum complex of Libya, and from the roiling frontier of North Dakota in the United States, a surge of new oil is hitting the market.

The result: moderate prices at gas pumps, and increased pressure on Iran. Although Iran has shown no sign of budging on its nuclear program, it has continued to participate in international negotiations. That alone is a political victory for the West.

"It's coincidental, but fortuitous," said David Goldwyn, the former U.S. State Department coordinator for international energy affairs in the Obama administration. "Oil sanctions have been more painful for Iran than they have been for oil market. Increases in production and reductions in consumption have more than made up for the loss of Iran."

Carrots and Sticks

Iran has endured U.S. sanctions for some 30 years. But since the first of a series of United Nations Security Council resolutions in 2006, international concern has mounted over Iran's uranium enrichment activities. Israel, which views nuclear weaponry in Iran as an existential threat, has threatened to strike unilaterally against Iran's nuclear complex. But the United States has rallied allies to use economic pressure against Iran even while engaging in negotiations; the most recent round of talks concluded last month in Moscow. But thus far, neither carrot nor stick has persuaded Iran to give up its nuclear activities, which it maintains are for peaceful purposes.

As of the end of May, the International Atomic Energy Agency reported that Iran has produced about 6,200 kilograms of uranium enriched up to 5 percent, and 146 kilograms enriched up to 20 percent. If Iran chose to further process that uranium to weapons grade (about 90 percent), it would be enough for four nuclear bombs, said Steven Pifer, director of the Arms Control Initiative at the Brookings Institution, during a June 29 forum at the think tank's Washington, D.C., headquarters. (Uranium for nuclear power plants typically is 3 to 5 percent enriched.)

Worldwide concern over the threat has resulted in what now are the most severe sanctions in history against Iran. As of June 28, under legislation passed by the U.S. Congress in December, foreign financial institutions that do oil-purchase-related business with Iran's central bank are cut off from transactions with the U.S. banking system. The European Union, which accounted for 20 percent of Iran's oil exports, in late January approved an embargo against Iranian petrochemical products and crude oil that went into full force July 1.

In an especially effective measure, the EU sanctions also bar European insurance companies from providing coverage for vessels carrying Iranian oil products. South Korea, in the past two years the consumer of 10 percent of Iran's oil exports, became the first major Asian nation to join in the embargo, citing its inability to rely on European insurers. Some nations, including Iran's number one importer, China, are considering sovereign insurance, in which the importing government itself assumes the risk of shipping mishaps. But China, Japan, India, Singapore, Turkey, and about 15 other nations, though still importing from Iran, have reduced import levels, and as a result received waivers from the U.S. sanctions. Even before the full embargo went into effect, Iranian exports were down 40 percent.

Sanctions were phased in gradually to give states time to find alternative supply. But as it turns out, the world's oil-consuming nations have had little difficulty replacing lost Iranian barrels. World oil production exceeded consumption by an average 1 million barrels per day in May and June, allowing inventories to build, said a report by the U.S. Energy Information Administration (EIA). The global benchmark oil price, known as Brent, was $92.94 per barrel by June 22, its lowest price since December 2010 and marking a 26 percent decline since March. Brent was trading in the high $90s last week, but still 20 percent below its peak for the year.

The fall in global oil prices has been key in giving the sanctions their bite. "It means for every barrel that Iran is able to export, they're getting far less money," said Goldwyn, who is now a private consultant and a nonresident senior fellow at Brookings. "In a tighter market, if oil had gone to $130 instead of going down, Iran might have reduced its exports, but the revenue might have been a wash." Instead, he said authorities project Iran's oil revenue will be down by $30 billion this year, a 33 percent decline.

Meanwhile, drivers in the United States were able to enjoy their July 4 holiday with an average pump price of $3.42 per gallon (90 cents per liter), the lowest since the first week of January. In the European Union, the average gasoline price of $7.01 per gallon ($1.85 per liter) marked a 4 percent slide since March.

Oil Supply Surge

The plentiful global oil situation stands in marked contrast to a year ago, when the revolt in Libya erased its 1.6 million barrels per day from the market entirely, and prices skyrocketed. But the oil fields were never damaged in the overthrow of Muammar Qaddafi, and Libya was able to reestablish production far more quickly than it could institute a new government. By the time Libya's first-ever elections were held July 7, oil production was already back nearly to prerevolutionary levels. The North African nation's light, sweet crude—easily processed into gasoline—is highly sought in Europe and sells at a premium over the sour grades produced by many of its fellow OPEC states in the Middle East, including Iran.

(Related: "Pictures: Oil States: Are They Stable? Why it Matters")

Meanwhile, new oil is hitting the market on both sides of the globe. New infrastructure in Iraq lifted production to 2.9 million barrels per day in May and June, its highest production level since 2000. In North America, Canadian production—led by the prolific oil sands of Alberta—is estimated to be up 10 percent, to 3.3 million  barrels per day this year, government figures show. And in the United States, a nation that until recently was believed to be in an irreversible decline as an oil producer, fields are pumping out 8 percent more petroleum than last year. The rise to 6.2 million barrels per day is largely due to new hydraulic fracturing technology that has forced oil from once-impermeable shale rock beneath the northern Great Plains. As a result, in March, North Dakota, with production growing an average 4 percent monthly, overtook Alaska as the nation's No. 2 oil producer, second only to Texas.

(Related: "Shale Oil Boom Takes Hold In the Plains," and "U.S. Oil Fields Stage 'Great Revival,' But No Easing Gas Prices")

But production is only half of the story. Consumption is also way down, partly due to the anemic global economy and financial crisis in Europe. From the point of view of the oil market and the effectiveness of Iran sanctions, said Goldwyn, "the fact that Europe is in shambles and the U.S. is not growing very fast helps." Far from increasing during summer drive season, global oil consumption is down 600,000 barrels per day compared to March, according to the last June report by the U.S. EIA.

And longer-term trends may be at work. In its closely watched Annual Energy Outlook, the EIA projected that energy consumption in the United States will not return to 2008 levels until 2021, even assuming 2.6 percent annual GDP growth and 0.9 percent population growth over that period. Thanks to more efficient cars, increasing use of ethanol to displace gasoline, and no increase in the number of miles driven per person, oil consumption in the United States is down nearly 10 percent from its 2005 peak. Low-priced U.S. natural gas is rapidly displacing heating oil, and has potential to oust diesel fuel for heavy truck and bus transportation. In any event, in the United States and much of Europe, most analysts believe the heyday in the growth of driving is over, and with the spread of electric cars and other efficient technologies, so is oil demand in those countries.

(Related: "Driving the Limit: Wealthy Nations Maxed Out on Travel?")

An Uneasy Calm

But even if developed nations stick to their leaner energy diet, there's no guarantee that prices at the pump will maintain their trim. One obvious threat now is retaliation by Iran, which has threatened repeatedly to blockade the Strait of Hormuz on its southern border. Since it is the chokepoint for 40 percent of the world's oil, a disruption would immediately cause world oil prices to soar.  But since that is the corridor through which all of Iran's own exports—mainly now to Asia—move by tanker, it would be a high-risk gambit. With the U.S. Navy confirming last week that it had moved new forces into the Gulf to support anti-mine operations to keep the strategic waterway open, most analysts believe any blockade by Iran's maritime force would be short-lived. "They can do it, but they can't sustain it," Goldwyn said.

(Related: "Iran's Undisputed Weapon: Power to Block the Strait of Hormuz")

But Iran has shown no sign of giving up its nuclear program, despite the economic pain that is already apparent due to the loss of a large portion of its mainstay revenue. The value of Iran's currency crashed earlier this year and citizens are living with spiraling inflation for food and other goods. But Iran also has taken steps to mitigate the impact of sanctions, for example, phasing out a large portion of its fossil-fuel subsidies, which until recently were the highest in the world, and replacing them with direct cash payments to citizens.

(Related: "Pictures: Eleven Nations With Large Fossil-Fuel Subsidies" and Interactive Map: "Fossil-Fuel Burden on State Coffers")

"This is a regime that is quite comfortable with austerity," said Suzanne Maloney, senior fellow at Brookings' Saban Center for Middle East Policy, who added that the historical context is important. Although in recent years, Iran may have been earning between $60 billion and $80 billion annually in oil revenue, its export earnings were as low as $6 billion a year in the mid-1980s when it was in all-out war with its neighbor, Iraq, she said.

For now, Iran has taken steps to avoid shutting down oil production, which could damage fields that already were in decline. So it has pumped the oil into storage using the tankers that have nowhere to go. "Iranians have already stored quite a bit of oil on tankers floating, with

their GPSs turned off, around the world," says Maloney. The New York Times reported how at least some of the ships had been repainted to conceal their origin, in hope of making it easier to find buyers. But such measures are not long-term solutions. "At a certain point, they're going to have a need to do something more drastic in order to get the oil to market," says Maloney. But no one knows whether the pressure will compel Iran to capitulate on its nuclear program or to retaliate against the embargo.

Maloney said many Iranians  recall with pride that the nation survived an international oil embargo between 1951 and 1954. That episode is better remembered for its ending, the U.S.- and British-led coup that installed Mohammad Reza Pahlavi as shah until the 1979 revolution, sowing the seeds of continued animosity toward the West that lives on in Iran today.

As for Iran's stand on the current oil embargo, said Maloney, "I would argue that they have explicitly adopted a kind of survivalist approach to these sanctions. It's quite clear, at this point, they believe that they can weather the storm."

This story is part of a special series that explores energy issues. For more, visit The Great Energy Challenge.

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