by Jeffrey J. Schott, Peterson Institute for International Economics
Article in Business Economics. Reposted with permission.
© Business Economics
For almost three decades, the United States has imposed economic sanctions against Iran in an effort to blunt Iranian support for terrorism. The current sanctions policy dates back to 1984, when the United States implemented sanctions in response to Iran's complicity in the bombing of the Marine Corps barracks in Beirut. Since then, in measured increments, the United States has imposed new restrictions on US trade with Iran targeted primarily at impeding development of the Iranian oil industry, reducing its main source of export earnings and its capacity to fund terrorism. More recently, the goals of the sanctions policy have broadened to deter Iran's nuclear program and the development of nuclear weapons.1
The main thrust of US sanctions has been to deter foreign investment in Iran's energy industries. The 1996 Iran and Libya Sanctions Act (ILSA) penalized companies investing over $40 million annually in Iran's oil and gas sector; from the second year of sanctions onward, the threshold drops to $20 million per year. ILSA gave the President discretion to waive the sanctions if the action was in the US national interest, and succeeding presidents liberally used this authority to avoid imposing penalties on major European oil firms. The ILSA had a five-year sunset but was extended twice, in 2001 and in 2006. Over those fifteen years, the growth of Iranian oil production stalled due to the combined effects of the sanctions and the gross mismanagement of the Iranian economy. But while growth was stunted, overall production did not significantly decline and rising world oil prices in recent years has yielded Iran substantial financial windfalls.
In June 2010 the ILSA was super-sized into the Comprehensive Iran Sanctions Accountability and Divestment Act (CISADA). The CISADA provides new sanctions against banks and foreign financial institutions that engage in transactions with Iran; increases criminal penalties for violating sanctions; allows state and local governments to divest their assets from or prohibit investments of such assets in foreign companies engaging in sanctionable activities.
Despite the ratcheting up of economic pressure over several decades, the US sanctions have not led to major Iranian policy changes. To the contrary, the external pressure has been used by Iranian leaders to deflect blame to the United States for their domestic economic woes. And while the sanctions have made it more costly and cumbersome for Iran to pursue terrorist adventures and develop nuclear weapons, the financial bite of the sanctions often has been defanged by rising world oil prices, allowing Iran to sell less and profit more.
The purpose of this brief history is to give some context for understanding current developments in the oil market, and the shift in US sanctions policy towards Iran. The latest iteration of US sanctions against Iran was enacted in December 2011 as part of the National Defense Authorization Act (NDAA). The law requires the imposition of sanctions against non-US financial institutions engaged in transactions with the Central Bank of Iran and other Iranian banks. Unlike past measures that sought to constrain Iranian production by reducing foreign direct investment in Iran, Section 1245 of the NDAA targets Iran's oil customers and threatens stringent extraterritorial sanctions against foreign financial institutions unless the country with the primary jurisdiction over those firms cooperates with US policy and significantly reduces their oil purchases from Iran. The law does not define what constitutes a "significant reduction," thus affording the executive branch some flexibility in negotiating cooperative policies with Iran's major customers. Violators would be barred from access to the US financial market, effectively blocking trade and investment with the United States.
To avoid past mistakes where sanctions led to increased oil prices, the new measures do not go into force unless the President determines that there are sufficient supplies of petroleum on world markets to offset the impact of significant reductions in the volume of Iranian crude. In March 2012, President Obama issued the requisite declaration and exempted Japan and the European Union for a renewable period of 180 days from the new sanctions scheduled to enter into force in late June 2012. On June 11, waivers were granted to South Korea, India, Turkey, and four other minor customers of Iranian crude (Malaysia, Sri Lanka, South Africa, and Taiwan) that also have cooperated with US and EU policy. On the statutory deadline of June 28, China and Singapore also received a waiver. As a result, none of Iran's main oil customers will be subject to the harshest US sanctions in 2012.
In parallel, the European Union enacted new sanctions against Iran in January 2012 that are designed to complement US measures and actually are much stricter in the short term. The sanctions prohibit all new contracts beginning January 23, 2012 for the purchase, import, or transportation of Iranian crude oil, petroleum products, and petro-chemical products. Importantly, these measures cover a wide swath of financial transactions, including insurance and reinsurance, and have made it very difficult to obtain private insurance for tankers transporting Iranian crude. All existing contracts related to crude oil and petroleum products concluded before January 23, 2012 must be concluded or executed by July 1, 2012 (or May 1 for petrochemical products). And as a consequence of the EU sanctions, the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system has barred designated Iranian banks from making or receiving payments using SWIFT services. Because of the insurance constraints and SWIFT exclusion, the financial noose around Iran is much tighter than in previous sanctions episodes.
The US and EU sanctions policies are biting. Sales of Iranian crude are down and Iran reportedly is offering incentives to sanctions evaders, indicating that the sanctions are lowering Iran's net revenues. However, the stringent sanctions, especially if maintained for a lengthy period of time, could create substantial friction between the transatlantic partners and Iran's largest customers. In recent years, China, Japan, India, and South Korea have accounted for approximately 60 percent of Iranian crude oil sales. In recent months, those countries have reduced their purchases of Iranian crude oil and hope to receive a waiver from the sanctions like that granted to Japan in March. At the same time, they are justifiably concerned about disruptions in the oil market, increasing oil prices, and a drag on economic growth.
Keeping the pressure on Iran will not be easy. Iran will undoubtedly try to divide the sanctions coalition by offering to negotiate constraints on its nuclear program in return for a relaxation of the restrictions on purchases of its oil, and then stretch out the negotiating process and implementation of their concessions—the diplomatic equivalent of Muhammad Ali's famous "rope-a-dope" tactic of wearing down opponents! Iranian leaders will test the durability of the sanctions coalition, hoping that in a short period of time their main customers will resume normal purchases and break ranks with the transatlantic powers—who in turn would not risk major trade disruptions with the major Asian economies that would result from the imposition of the harsh financial sanctions.
Thus, the United States and European Union face a tough challenge in encouraging countries to comply with their sanctions policies and sustaining that pressure over time until Iran is forced to compromise. To encourage compliance, and to hold the sanctions coalition together, two concrete actions should be taken. First, US and EU officials should obtain commitments from Saudi Arabia to cover potential shortfalls in world markets by replacing oil previously purchased from Iran with additional sales of comparable Saudi crude. Second, the United States should pre-announce the release of surpluses of its strategic petroleum reserves (SPR).2 Combined, these measures would help reduce the likelihood of a significant oil price increase and hopefully discourage Iran from pursuing its costly weapons development program.
1. For the historical details, see the US v. Iran case study included in Gary Hufbauer, Jeffrey Schott, Kimberly Elliott, and Barbara Oegg, Economic Sanctions Reconsidered (3rd edition), Washington: Peterson Institute for International Economics. Updates to the case study through early 2012 are included in the online version [pdf].
2. For a detailed analysis on how the SPR could be used to support the sanctions policy, see Philip K. Verleger, Using US Strategic Reserves to Moderate Potential Oil Price Increases from Sanctions on Iran, Policy Brief 12-6, Washington: Peterson Institute for International Economics.
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