The Unintended Consequences of an Oil Embargo on Iran

[Copy of my post on The Monkey Cage]

On January 30, the European Union will decide whether to place an oil embargo on Iran in an attempt to dissuade it from its nuclear weapons ambitions. This would add to the existing sanctions recently put in place by the United States and Europe on financial transactions with the Iranian central bank. The trouble with such an embargo is that it could drive Iran into the waiting arms of the Chinese.

While the nuclear nonproliferation goal is certainly laudable, policymakers need to weigh the potential benefits of the sanctions against their costs – some of which are not well understood. Currently, most attention focuses on two issues. The first is the transaction costs associated with European refiners needing to switch to other suppliers. The plan to phase in the embargo should make these costs manageable.

The second is Iran’s threat to close the Straits of Hormuz in reaction to such sanctions. Such a threat could be very damaging, but it is also fairly unlikely, as Caitlin Talmadge points out. This threat should not be ignored, but neither should it be the sole focus.

The real problems are the potential unintended consequences. The market for oil is global. In the absence of a genuinely multilateral action, a European embargo on Iranian oil will only cause Iran to find new customers in Asia, especially in China. China’s growing thirst for oil and other resources is such that it will happily absorb such supplies, especially if they come at a discount.

EU countries bought about $15 billion worth of oil from Iran in 2010, according to UN data. An embargo would shift that business to China instead, deepening the relationship between Iran and China. What easier way to ensure China continues to protect Iran from UN sanctions in the future?

Worse still, the more successful the embargo is, the more it will deepen Iran’s relationship with China. An embargo has the potential to impose two kinds of costs on Iran. First, in the short-term, Iran’s previous oil sales to Europe will be disrupted while it reorients its sales to new customers. Yet previous embargos suggest that a re-jiggering of oil flows can be done quickly, in a matter of weeks. And to the extent that the EU embargo is done gradually, Iran will be able to reduce this disruption.

So the main cost to Iran of an embargo would be the discount it would have to offer to new customers to replace its previous sales to Europe. This is the second kind of cost, and it could be long-term. Yet either these discounts are small, in which case the sanctions are not hurting Iran much, or the discounts are large, which will create a very profitable relationship for Iran’s new customers – and thus one that they would be loath to give up. The largest new customer for Iran is likely to be China, and hence the problem. The EU oil embargo could enamor the Chinese to their Iranian oil suppliers.

Just as importantly, oil embargos have a long history of futility and unintended consequences.

The embargo on Iraq’s oil after Saddam Hussein’s invasion of Kuwait in 1990 is a case in point. The sanctions were ineffective, laden with corruption, and had perverse consequences. It was ineffective because its chief target, Saddam Hussein, hung on to power until after the sanctions had ended. It was corrupt because it created opportunities for graft in the United Nations, causing a scandal that went all the way up to then-Secretary General Kofi Annan. And it had perverse consequences because it principally hurt lower- and middle-class Iraqis, depriving them of basic economic necessities.

Similarly, the United States imposed a unilateral oil embargo against Libya in the 1980s, and made little headway in changing the Qadhafi regime’s behavior until the UN imposed multilateral sanctions in the 1990s. The UN sanctions were targeted at Libyan elites and government officials, and included travel bans and financial restrictions – but not an oil embargo. Over time, the UN sanctions appear to have taken a significant toll, contributing to Qadhafi’s eventual decision to give up his nuclear weapons program.

None of this necessarily means that the EU is wrong to impose an embargo on Iran. Particularly if the embargo can generate significant leverage in the short-term, perhaps by engendering an increased sense of global isolation among the Iranian public, it might be justified in the name of nuclear non-proliferation.

Yet oil embargoes should not be undertaken lightly, as they frequently generate significant unintended consequences. Policymakers contemplating one should have their eyes wide open.