Pros and Cons of an Iran Oil Embargo

The biggest worry is a further spike in oil prices and that is considerably overhyped

I’ve been advocating for an embargo of Iranian oil for some time. The reason I’ve been doing this is because most options for military escalation - like bombing Iran’s power plants or taking Kharg Island - are equivalent to an embargo in terms of outcomes but may involve significant loss of life on both sides. After all, if we take out Iran’s power infrastructure, there’s no electricity to pump oil into docking super tankers, so this is a de facto embargo. If we successfully occupy Kharg Island, Iran will switch off any oil flowing to the island, so - again - this is a de facto embargo.

Better to do a proper embargo, which would mean announcing that any fully laden ships transporting Iranian oil will be interdicted and seized. Given the overwhelming US military superiority in the Gulf, I highly doubt a single oil tanker will test this, so Iran’s oil exports would go to zero overnight. The single biggest pushback to my view is that this could spike oil prices still further, given how tight global supply already is. Today’s post goes through the pros and cons of an embargo. I’m going to start with the cons, which are top of mind for US policy makers right now.

Cons to an Iran oil embargo:

• Risk of a further oil price spike: as I laid out here and in last week’s podcast with Paul Krugman, the 60 percent rise in Brent from before the war prices significant, permanent impairment of oil supply out of the Persian Gulf. If we assume oil out of the Gulf now runs permanently at 10 million barrels per day versus 20 pre-war, that maps into a 67 percent rise in Brent for a price elasticity of demand of 0.15 as the lower red dot in the chart below shows. If Iran is embargoed, that removes its two million barrels of oil per day - on top of the 10 million barrels already missing - and implies an 80 percent overall rise in Brent (the upper red dot). Taking Iran’s oil off the market therefore clearly pushes prices up, but that rise is moderate and - with Brent at $110 - this is increasingly priced. Scenarios where Brent goes to $150 of $200 are in my opinion unrealistic.

• Risk that Iran’s economy doesn’t immediately implode: as I’ve noted previously, Iran is a gas station masquerading as an Islamic Republic. Much like Russia, its economy runs entirely on energy exports, which pay for everything else. The chart below shows that the current account surplus (black line) is entirely due to energy exports (blue bars), which pay for imports (red bars) and everything else. An oil embargo drastically cuts the blue bars, which means there’s far less money to pay for imports. This leads to a sharp depreciation of the currency and hyperinflation, hitting Iran’s population hard. There is no telling how quickly this destabilizes the regime - countries like Iran care little for the suffering of their people - but I think the economic implosion will be deep enough to bring the mullahs to the negotiating table relatively quickly and in good faith.

• Risk of a financial market accident in the US: as oil prices have risen in recent weeks, signs of stress in US financial markets have mounted. This is what I’m most worried about. We have a lot of skeletons in the closet, from the basis trade to private credit. A sustained rise in volatility destabilizes these carry trades and can potentially blow them up. That said, we have the tools to deal with this kind of stuff, as the Fed’s emergency QE in March 2022 showed.

• Risk of a Baltic curveball: Ukraine will be watching Iran’s blockade of the Strait of Hormuz with dismay. If only the West had acted to impose a similar embargo on Russia in the days after the invasion, perhaps that war would have ended long ago. There are now signs that Ukraine is stepping up drone attacks on Russia’s main oil export hubs in the Baltic. If these are materially impaired, that could add upward pressure to oil prices. Given Ukraine’s dependence on US weaponry and intelligence, I think Ukraine can be persuaded to take it easy on all this.

Pros to an Iran oil embargo:

• No more mixed messages: the biggest mistake the West made after Russia invaded Ukraine was to send mixed messages. On the one hand, it wanted to punish Russia, but - on the other hand - it wanted to avoid an oil price spike. These two things are in conflict and that - ultimately - worked in Putin’s favor, with Russia still waging war in Ukraine over four years later. An embargo of Iran avoids this mixed messaging. It sends a clear signal that the US is willing to bear some temporary pain in the form of higher oil prices if that’s what it takes to oust the mullahs. That message will be heard loud and clear by the people of Iran, which has to raise the odds of regime change.

• A non-violent approach: as I mention at the outset, military escalation will likely result in an embargo-like outcome, so why not just do an actual embargo, when this also means much lower risk of serious loss of life. If need be, military escalation can always be done if the regime doesn’t falter fast enough.

• This is non-escalatory: Iran is de facto embargoing a large chunk of oil that ordinarily transits the Strait of Hormuz. Iran will complain bitterly in the event of an embargo, it’s an existential threat after all. But it can’t credibly portray a US embargo as an escalation. An embargo of Iranian oil will just be a quid pro quo for what Iran is doing to the rest of the world.

• Leverage over China: China is the biggest buyer of Iran’s oil. It has us over a barrel on rare earths. An embargo would help build leverage over China, which could put the US on a better footing in those trade negotiations. The advantages to an embargo thus conceivably go beyond Iran.

My bottom line on all this is that a short, sharp shock is infinitely preferable to an interminable mess, which is what we might get if we allow Iran to keep exporting oil. You never know with certainty what the counterfactual is, but I feel pretty certain that - if the West had embargoed Russia in 2022 - the war in Ukraine would be over by now. That’s the key lesson we should now bring to dealing with Iran.