Why the Iran Oil Sanctions Are Biting

Last week the Obama administration tightened its oil-related sanctions against Iran. This was followed by new congressional legislation that promises to extend those sanctions further. Yet less than a year ago, most observers found such stringent sanctions against the Iranian oil sector unthinkable.

What has happened to so fundamentally change the picture? It’s worth looking at three things.

A Change in Politics

There is no question that the Obama administration was initially less enthusiastic about oil sanctions than Congress was. But political power moved in ways that gave Congress more control. Ultimately, the administration struck a bargain rather than try to defeat sanctions legislation. It got language that allowed it to exercise extensive discretion in applying the sanctions: it could hold off if the economy would be put at substantial risk; it could also exempt other countries that were making solid efforts to wean themselves off Iranian crude. The decision to cooperate with Congress was critical – it opened the door for other factors to push the United States further down the sanctions road.

A Change in Philosophy

For years the basic debate over oil market sanctions was simple. One side said that the Iranian threat was so great that any tool that could put pressure on Tehran should be used. The other side said that the price was too high: blocking crude shipments from Iran would tighten world oil markets, raising prices for gasoline and diesel, and threatening to bring the economy down. Both arguments gained strength over time: the Iranian nuclear threat advanced, increasing the urgency of raising pressure; meanwhile, a weak economy made policymakers allergic to anything that might threaten recovery. In any case, many agreed, sanctions could easily be undermined, since China would continue to buy Iranian crude.

In late 2011 another strain of thinking rose in prominence. The logic was straightforward. Most countries would shun Iranian crude. A few, though, would continue to buy it. Since Iran would now be desperate for customers, though, it would be forced to offer the crude at a discount. Iranian revenues would fall but world oil supplies wouldn’t; as a result, world oil prices would remain stable. Chinese purchases of Iranian crude had become a selling point rather than a flaw.

This theory hasn’t quite played out in practice. China has been able to extract discounts, but Iranian exports have also been slashed in half. Regardless, the change in philosophy was essential to getting the sanctions rolling in the first place.

A Change in Markets

Over the long run oil markets tend to do a good job of balancing supply and demand. Over the short run they’re considerably quirkier. A central question when people debated Iran oil sanctions a year ago was whether Saudi Arabia could quickly make up for lost Iranian crude. If they did, markets would remain well supplied, without prices needing to rise; if they didn’t, all hell could break loose. Indeed even a strong response from Saudi Arabia was not without potential problems, since a surge in output would have left Riyadh without much spare capacity left in case of other problems.

But two big market trends came to the rescue. The first was a surprisingly weak global economy, which left oil demand below the levels that many had expected. The second was the surge in U.S. oil production, which has risen by nearly a million barrels a day over the last year. Over the long run, that much extra production has limited consequences for world oil markets and prices, which adjust considerably to compensate. Over the short run, though, it’s critical. Surprise gains in U.S. output have largely offset surprise falls in Iranian exports. The result for markets has been nearly neutral, something that crude oil prices reflect.

Each of these three factors hold lessons as the sanctions proceed. Politics will continue to shape U.S. decision-making. Expectations that China can absorb Iranian oil at a discount seem to be on the wain. Sustained gains in U.S. oil supplies no longer come as a surprise to markets – and continued weakness in the global economy isn’t much of a shock either. All of these factors may make ever-tighter sanctions an increasingly challenging task.

And it’s important to keep the big picture in mind. Sanctions alone will not solve the Iranian nuclear problem. They need to be combined with effective diplomacy to have a real chance of success. Pulling that off is a far taller task than imposing the sanctions in the first place.