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BW Businessworld

A Slow Burn

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The pressure is building. Political leaders in the United States and Europe could soon face an uncomfortable choice between raising the pressure on Iran further or taking steps to safeguard their economies from the damage wrought by rising oil prices and looking at alternate sources of energy.

The simplest step to counter the rising prices of course challenges the very concept of sanctions — encouraging more Iranian exports to China, India and other markets across Asia. The original sanctions "game plan" called for rising exports of (discounted) Iranian crude to China and other developing markets to offset the loss of market access in Europe, Japan and Korea and keep global oil supplies steady.

That plan has gone wrong because Iran has so far refused to offer large enough discounts and many Asian buyers are wary of taking Iranian oil and relying on uncertain US forbearance from enforcing penalties.

White House Press Secretary Jay Carney said on Wednesday: "The rise in gas prices is clearly the effect of a variety of factors on the global price of oil. They include unrest in certain regions of the world. They include growth in areas like China and India." The recent hike in global oil prices underscores the need to improve upon the alternate sources of energy, he said.

But the very same day, Bharat Petroleum, India's second-biggest state refiner, turned to Saudi Arabia, the world's top oil exporter, for higher supplies in 2012/13, fearing global sanctions may jeopardise trade with Iran, industry sources said on Wednesday. It is the third Indian company after Hindustan Petroleum and Mangalore Refinery and Petrochemicals Ltd to seek higher volumes under term deals from Saudi Arabia.

Saudi Arabia is the biggest oil supplier to India, the world's fourth-biggest oil consumer, and is the only oil producer with significant spare capacity to replace any fall in supply from its regional rival Iran.

Iran has offered extra oil supplies to Asian buyers as it seeks to retain market share in the face of western sanctions aimed at stopping Tehran using its nuclear programme to develop weapons. Iran denies it has such an ambition.

While India has said it will not implement the sanctions, it, along with China and Japan, are planning cuts of at least 10 per cent in Iranian crude imports as US measures make it difficult for the top Asian buyers to keep doing business with the OPEC producer.

Confrontation with Iran and a series of supply disruptions in South Sudan, Syria and Yemen have pushed prices back to levels that derailed the recovery in the United States and Europe last year, and could do again in the first half of 2012.

If prices continue rising, releasing oil from government-controlled stockpiles will look attractive to policymakers keen to maintain the embargo but anxious to avoid a stalling economy in a US election year.

"That has resulted in more domestic oil production than we've had in the past eight years, greater sales of leases in the Gulf and elsewhere to increase our production, the reduction in our reliance on foreign energy sources," he said.

Carney said these are the kind of policies that have long-term, positive impact on the American economy and on national security.

The Iranian nuclear row and related oil price jump appear to have swooped back onto the radar for global investors just as Western credit woes seem to be easing - but energy risks may well now be an ever-present menace.

After six months digesting euro sovereign and banking crises and the odds of another global recession, world markets have bounced back smartly in 2012. Worst-case scenarios have been dodged, and the residual pain has been eased by another flood of central bank cash and monetary easing worldwide.

Political leaders across North America and Europe are convinced of the need to maintain sanctions on Iran's exports and continue pressuring the government in Tehran to curtail its uranium enrichment programme. Facing a tough re-election fight later this year, US President Barack Obama cannot afford to show any sign of weakness in foreign policy, especially towards Iran.

On the other hand, the president's re-election hopes could be sunk if rising oil prices push the economy into recession. European governments could also be vulnerable if voters blame rising oil prices on sanctions and conclude the embargo was an own goal.

Political pressure to cap or reverse the rise in oil prices is already high. It will become intense if prices break through last year's highs around $125 (Brent) and $110 (WTI) and the rise is blamed on the sanctions process.

Stuck Above $100
And just as importantly for many economists, oil prices never had a weekly close back below $100 for the rest of the year despite a demand-sapping euro crisis, double-dip recession warnings stateside and rapidly slowing emerging economies.

Only last month, the International Monetary Fund slashed its global growth forecast for this year by 0.7 percentage point to 3.3 percent. However, citing worrisome geopolitics, it left its baseline petroleum price projection for the year largely unchanged at $99 per barrel compared to $100 previously.

And if those political tensions are on the rise again and the global economy - or at least the world's biggest economy - is stabilising, there is justifiable concerns about another sustained and growth-smothering oil price surge.

Bank of America Merrill Lynch economists reckon oil will not fall back below $80 per barrel over the next five years, and supply constraints mean they could even spike as high as $200.

US Action
The Obama Administration, has taken a number of actions from increasing domestic oil production to increasing domestic gas production, the lease sales. Efforts are on to increase fuel efficiency to reduce dependence on foreign energy.

"This kind of situation that comes periodically because of a rise in the price of oil globally often results in magic solutions being put forward by politicians who may or may not know what they're talking about," Carney said.

"But the fact is you have to have an approach that's comprehensive, that takes a long-term look at reducing our dependence on foreign sources of energy, increasing domestic production, and developing alternative sources of fuel. And that's the approach the ( US) President is taking," he said.

"We can reduce our reliance on foreign sources of energy if we expand in every direction - if we increase oil production, increase gas production, increase our investments in alternative energy, and take dramatic action, like he did with the fuel efficiency standards, the dramatically reduce our consumption of oil and save Americans $1.7 trillion in costs," he added.

Delayed Reaction
Experience suggests the full extent of the damage will not be apparent until the second or third quarter, because oil prices filter through to measurable changes in consumer spending and business investment with a lag of several months.

The best way to understand how oil prices are likely to affect the economy is to examine how the recovery was influenced by the last big rise and fall in prices between August 2010 and April 2011.

Between August 2010 and January 2011, front-month Brent prices rose $20 per barrel (25 percent) following Fed Chairman Ben Bernanke's Jackson Hole speech foreshadowing a second round of quantitative easing, and then another $26 (27 percent) between February and April following the outbreak of the Libyan civil war and the earthquake at Fukushima.

Throughout the period the economy appeared impervious. Many oil analysts dismissed reports of demand destruction as "premature" and predicted prices would need to rise much further to bring demand back into line with restricted supply .

Equity prices rose strongly. The Standard and Poor's 500 index rallied over 20 percent between August 2010 and April 2011.

The US economy continued to report big gains in manufacturing output and employment. The Institute of Supply Management's (ISM) composite manufacturing index averaged 58.5, well above the 50-point threshold dividing expanding activity from a contraction. Private sector employers averaged payroll gains of 185,000 positions per month.

Then it all went wrong. May proved to be the cruellest month. Oil prices plunged, but too late to save the recovery .

Private sector job gains slumped from 264,000 in April to 108,000 in May and 102,000 in June. The ISM composite collapsed more than 5 points, and another 4 points by July.

The economy stalled, prompting the Federal Reserve to promise further stimulus at its August meeting in the form of a soft commitment not to raise interest rates until at least the middle of 2013.

Curbing Oil Price Rises
Assuming that tensions with Iran cannot be defused, and policymakers opt to maintain sanctions, there are a number of options for trying to blunt the economic impact.

The simplest would be to encourage more Iranian exports to China, India and other markets across Asia. The original sanctions "game plan" called for rising exports of (discounted) Iranian crude to China and other developing markets to offset the loss of market access in Europe, Japan and Korea and keep global oil supplies steady.

The plan has gone wrong because Iran has so far refused to offer large enough discounts and many Asian buyers are wary of taking Iranian oil and relying on uncertain U.S. forbearance from enforcing penalties. U.S. officials could, however, re-emphasise that a certain level of "permitted non-compliance" is assumed and even encouraged.

Such messaging is difficult to get right. But arguably U.S. and European officials could do more to reassure Asian crude buyers that they will not be punished for buying Iranian crude.

The second option is to try to resolve some of the other disruptions currently affecting oil supplies. Western governments may not be able to do much about the loss of crude from Syria, but officials could step up pressure on Sudan and South Sudan to settle their dispute over transit fees.

IEA Stock Release?
The third option is to order another release from government stockpiles. So far, officials have implied stocks would only be released in the event of a disruption to oil flows through the Strait of Hormuz. In reality, the conditions for release are likely to be interpreted more flexibly.

A pre-emptive release of supplies to forestall a dangerous rise in prices is probable if officials assess there is a threat of Brent prices breaking through the $125-130 level.

Stock releases are above all a political decision. If prices continue rising, the pressure to counter them by releasing stocks may become irresistible.

(With Agencies)