(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON Feb 28 (Reuters) - U.S. and EU sanctions on Iran's crude oil exports and its central bank were not supposed to affect either the volume of oil available or its price, provided markets reacted "rationally".
That was the conclusion of an influential report on the "Oil Market Impact of Sanctions Against the Central Bank of Iran", circulated by sanctions advocates at the Foundation for Defense of Democracies in Washington.
The idea that sanctions could reduce Iran's oil revenues without boosting prices for oil-consuming countries was crucial to persuading policymakers in the United States and Europe to impose far-reaching restrictions on Iran's oil sector.
But the policy has backfired. Oil prices have surged, harming consuming countries and offsetting the impact of lower exports on Iran's revenues.
U.S. and EU sanctions were written very carefully to include plenty of flexibility to ensure they would not risk a spike in prices.
U.S. sanctions, set out in Section 1245 of the National Defense Authorisation Act for Fiscal 2012 (HR 1540), apply only if the president determines "the price and supply of petroleum and petroleum products produced in countries other than Iran is sufficient to permit purchasers .. to reduce significantly in volume their purchases from Iran".
Sanctions do not apply if the president determines an importer has "significantly reduced" its volume of crude purchases from Iran, and the president can waive them altogether if it is in the national interest.
The law mandates experts at the Energy Information Administration (EIA), in conjunction with the departments of Treasury and State and the head of the intelligence community, to review the availability of alternative supplies every 60 days. The first review is scheduled to be delivered to the U.S. Congress this week.
For supporters, the game plan was (1) to divert Iranian crude away from developed markets in Europe and Asia to developing countries; (2) grant emerging markets a pass provided they cut imports or negotiate steep discounts for Iranian oil; (3) line up alternative sources of supply by extracting promises from Saudi Arabia to boost exports; and (4) maximise publicity for all these arrangements to ensure oil markets did not bid up prices on supply concerns.
It has not worked. Brent oil prices have risen around $25 per barrel, or 25 percent, since sanctions momentum first started to build in earnest in late October/early November, and almost $18 since they were signed into law.
The steeply backwardated structured of futures markets suggests there are concerns about the availability of alternative supplies, despite Saudi offers of extra barrels. Hedge funds and other money managers have boosted long exposure to crude futures and options by more than 80 million barrels since the start of November and by more than 65 million since the start of the year.
Two things have gone wrong. First, sanctions are interacting with other supply disruptions (in South Sudan, Yemen, Syria) to reduce supplies and exhaust the cushion of spare capacity Saudi Arabia holds.
Second, the thicket of sanctions on Iran imposed by the European Union and United States is now so complex it is becoming hard to conduct trade that is supposed to be permitted.
A provision for permitting countries to continue buying Iranian oil provided they reduce the volumes or secure a U.S. presidential waiver is not much help if cargo and shipping insurance is not available because of other sanctions restrictions.
Sanctions strategy rested on the concept of permitted non-compliance and selective prosecution by the United States of countries and refineries that continued to purchase Iranian crude. But the sheer level of arbitrariness makes normal commercial activity almost impossible. Importers fear their waivers and permitted non-compliance could be removed at any time.
The result is that many emerging markets have not taken up the extra Iranian barrels no longer being delivered to Europe, and most are scrambling to cut their reliance on Iranian imports.
Sanctions cannot be blamed for the entire increase in oil prices. Other stoppages, sabre-rattling by Israel and Iran, an improving U.S. economic outlook and another bout of massive monetary stimulus from global central banks have all helped push up prices.
Sanctions supporters argue that Iran's nuclear programme required some response and that sanctions were the least bad option. Military confrontation would have generated an even bigger rise in prices and more uncertainty and damage for the global economy.
But sanctions (especially those legislated by the U.S. Congress) are a notoriously blunt instrument with a questionable track record. In this case, the potential for sanctions to backfire, imposing significant costs on consuming countries, was well understood by outside observers as well as many energy experts within the U.S. administration and European governments.
Unfortunately, the political momentum for sanctions outstripped a proper analysis of the likely impact. In November and December, both the United States and the EU found themselves publicly and politically committed to a sanctions strategy before the detailed technical work had been done to assess the likely impact on Iran's revenues and oil prices.
By the time foreign policy officials began reaching out to colleagues in energy ministries as well as experts in the industry and at the International Energy Agency at a series of meetings late last year and in January, the momentum for sanctions had already become unstoppable.
REFINING THE STRATEGY
Oil sanctions are a classic example of poor policymaking under pressure from outside influences with insufficient attention being paid to detail and seeking expert input. The consequence is visible in the sharp rise in the cost of gasoline and diesel hitting consumers and businesses across North America and Western Europe.
It is likely sanctions policy will be refined in the coming months to soften the impact on consumers as well as reverse the rise in oil prices, which is currently benefiting rather than hurting Iran.
Neither the United States nor the EU is likely to lift sanctions, unless and until there is significant progress in engaging with Iran, which at the moment seems a relatively distant prospect. But there are less visible steps that could be used to adjust their impact.
The EIA's first 60-day assessment of alternative supplies will provide an opportunity to examine how sanctions are interacting with other disruptions and whether Saudi Arabia is managing to plug the gap.
In another 30 days, the president will make the first determination of which countries are significantly reducing the volume of their imports. Waivers and non-applicability decisions will allow the White House to start demonstrating some flexibility in an attempt to reassure markets.
Intense diplomatic pressure will be applied to Sudan and South Sudan to resolve their dispute over transit fees.
Western policymakers may also step up the pressure on Saudi Arabia to increase its exports and go public about how much extra oil is flowing. There is also likely to be an effort to reassure Asian refiners in China, India and certain other markets they will not be penalised for continuing to take Iranian crude, especially if they secure discounts.
Finally there is likely to be a renewed push to explain the impact of sanctions to financial investors in a bid to get the market to view them in a way that policymakers see as more rational.
Whether all this will be enough to avert a further damaging rise in prices is unclear. But having set the process in train, the onus is on foreign policy officials and sanctions supporters to show the consequences can be controlled. (editing by Jane Baird)