Iran Oil Price Risk Returns

Between the Libyan revolution and the shaky US and European economies, oil markets hadn't been paying much attention to Iran's nuclear program until last week's release of a new report from the International Atomic Energy Agency (IAEA.) For the first time, the IAEA presented a detailed picture of a well-organized Iranian effort encompassing projects and technologies that go beyond what could reasonably be construed as having purely civilian purposes. Traders are once again talking about an "Iran risk premium," though the market's initial response has been sufficiently muted that it's hard to distinguish from other factors, such as the narrowing of the spread between West Texas Intermediate and Brent crude and worries about the Euro. As long as the international reaction to Iran remains confined to the well-worn pattern of diplomatic protests followed by incrementally tweaked sanctions that dampen speculation about military options, oil will probably just exhibit some extra volatility.

I've been following this issue for a long time, and almost from the start I've been skeptical of the Iranian government's insistence that their nuclear effort was aimed only at producing electricity. Iran has cheaper and less controversial energy options in abundance. Perhaps the biggest surprise in the IAEA report was that the agency would risk the controversy inherent in releasing a thorough accounting of Iran's efforts to develop capabilities unique to designing and building a nuclear warhead that could be mounted on a missile. Moreover, the report suggests that at least some of these activities did not end in 2003, as the controversial US National Intelligence Estimate of 2007 concluded, but "may still be ongoing."

The oil market risk has several dimensions, the most obvious of which relates to a preemptive attack by the US or Israel. Yet even a stepped-up sanctions regime might either directly impede oil exports from Iran or provoke an Iranian reaction having the same effect, at a time when oil prices are already relatively high. Either scenario might trigger an oil price spike that would largely undo recent efforts to revive the global economy. At the moment, however, neither outcome seems very likely to me.

Whatever the IAEA's findings indicate about Iran's intentions or proximity to becoming a nuclear weapons state, the US has little appetite for initiating an attack with such uncertain outcomes on the basis of intelligence that remains incomplete. The public is hardly clamoring for another war, and the administration seems understandably reticent to take such a step, particularly going into an election year. Israeli public opinion--and even its leaders--appear split on the advisability of independent action against Iran's nuclear complex. Even in terms of sanctions, I would expect a response with more bark than bite that stops short of antagonizing Iran's regime to the point at which it might use its oil weapon. Unfortunately, the longer this protracted confrontation over Iran's nuclear program drags out, the greater the risk of one or more parties miscalculating, with results that could spin out of anyone's control.

The Council on Foreign Relations has put out some useful interviews and analysis on the IAEA report and the possible responses to it. Have a look and draw your own conclusions.

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Putting a Price on Risk

I spent most of the day in Richmond yesterday attending the first Summit on Virginia's Energy Future. I'll write more about the main topic of that session next week, but a statistic from one of the panelists stuck in my mind for the entire drive home. In describing the risks that utilities take on when investing in new power plants, the President and Chief Nuclear Officer of Dominion Virginia Power, David Heacock, explained that over the sixty year life of such a facility, the cumulative difference between their high and low long-term natural gas price forecasts amounted to $7 billion, equivalent to the entire up-front cost of a nuclear power plant. He also suggested that the value of the difference between their high and low forecasts for the price likely to be imposed on CO2 emissions was in the same ballpark. Despite the recent financial crisis and accompanying loss of confidence in sophisticated risk-monetizing mechanisms that failed so spectacularly to account for low-probability events, some businesses have no choice but to assess risk in terms of its dollar impact. And as government fills in for a number of hopefully-temporary gaps in various markets, it must also grapple with risk in this way.

The President's proposal to quadruple the total loan guarantees available for new nuclear power plants has raised some concerns about the cost of backing loans to an industry that has suffered spectacular defaults in the past. Doubtless many of my readers are too young to remember the WPPSS (or "Whoops") default in the early 1980s. The amount in question, $2.25 billion, would seem more like a rounding error in today's inflated terms, but that was a lot of money at the time, and it caused quite a stir. I don't believe the Whoops precedent is relevant to today's emerging nuclear renaissance, other than as a reminder--as if we needed one after the last couple of years--that the risk of default is never zero, and a loan guarantee always costs something.

I also find it interesting that worries about the cost of such guarantees have come up mainly in the context of nuclear power, while loan guarantees, loans and outright grants to a variety of "green" projects and firms have attracted little comment along these lines. A case in point is the widely-celebrated $529 million federal loan--that's loan, not loan guarantee--to Fisker Automotive. As with today's nukes vs. Whoops, there may be no direct analogies to the DeLorean experience or various other sorry episodes in the history of the car business, other than to remind us that the risk of default on that loan is also not zero.

As another speaker at yesterday's session pointed out, we are in an extraordinary time, in the aftermath of a financial crisis and with credit for many firms still frozen. At such times, the government may have to step into roles that are otherwise better left to the private sector, such as financing auto start-ups and backstopping loans to power plants. When that happens, our proper attitude towards the risk that we are taking on collectively is neither to sweep it under the carpet, as has largely been done with various green loans and loan guarantees, nor to assume it approaches 100%, as some seem to be doing in the case of nuclear power. The magnitude of these risks can be quantified and weighed against the cost of doing nothing. It can also potentially be reduced through judicious diversification--recognizing that the government itself controls some of the key risks of default through another of its powers, to regulate. With great power comes great responsibility, and those wielding it today should consider that carefully, as they would be called to account later should some recipient of one of these loans or loan guarantees ever default. Now, that's a 100% certainty.

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Resolving Iran Oil-Price Risk

It hasn't been easy keeping up with all the recent developments related to Iran's nuclear program, which still looms as a large, unresolved risk embedded in the global price of oil--though you would never know it from the behavior of oil markets in the week since Iran's hidden nuclear enrichment site was revealed. It's not clear whether traders have concluded that the exposure of the Qom site strengthens the hand of the US, Britain, France and Germany sufficiently to make a diplomatic solution likelier--and conflict correspondingly less likely--or the impact of this story has been overwhelmed for the moment by weak market fundamentals. After all, this is merely the latest phase of a crisis that has been simmering for a number of years; a wait-and-see attitude looks prudent, particularly in light of the market's current capacity to adjust for the temporary loss of Iran's oil output, should that ensue. However, I believe that we are also approaching the point at which much of this uncertainty resolves, because fairly soon the US and its allies must choose either to act decisively to prevent Iran from acquiring nuclear arms, or relinquish those options and focus on containing the threat.

Our relative torpor on the subject of Iran's nuclear enrichment program and that country's ultimate nuclear ambitions has been jolted by a succession of events this month. First, President Obama announced his intention to abandon the development of land-based anti-ballistic-missile sites in Central Europe, the main purpose of which was to intercept Iranian ICBMs on their way to targets in Europe or the US, in favor of a sea-borne strategy focused on shorter-range missiles. Then came the announcement at the G-20 meeting in Pittsburgh that Iran was building a secret uranium enrichment site that could start operations as soon as next year, potentially capable of producing roughly one atomic bomb's worth of weapons-grade material a year. Neither the fact that the US and its allies have apparently known about the Qom site for several years nor the last-minute disclosure of the facility by Iran to the International Atomic Energy Agency seemed to dampen the shock effect of the announcement. After customarily glib excuses, the Iranian regime's next step was to test-fire short- and medium-range missiles. The US has demanded immediate inspections of the new facility, and the UN Security Council meets tomorrow to take up these matters.

So where does this leave us, other than with nerve-wracking reminders of the pre-war situation with Iraq? If we've been paying attention, the latest revelation shouldn't have come as much of a surprise. As I explained at length in 2005, the arguments that Iran's enrichment efforts were aimed at anything other than a nuclear weapons capability were always pretty weak. Stripping away the diplomatic language of the US and its allies and the lame obfuscations from Tehran, the uncovered Qom facility leaves scant room for doubt concerning the determination of the Iranian government to militarize its nuclear program. Whether or not it is also currently developing warheads that would use the uranium enriched at sites like the one at Qom, there is no other plausible reason for building a nuclear facility in secret under a military base. And common sense tells us that, as with mice, where there is one there are very likely others.

What I conclude from all this is that we are approaching a set of distinct decision points, after a long and intricate dance that probably served the interests of both parties. The passage of time has allowed Iran to make steady progress on enrichment and missile technology, but it has also opened up options for us. As I noted last fall, lower oil prices have created a window for a set of actions--truly crippling sanctions, a naval blockade, or air attack on the facilities in question--that would have been unthinkable when oil was marching steadily toward $100/bbl and beyond. That window will begin to close once the global economy resumes growing rapidly enough to erode the healthy cushion of spare global oil production capacity that now stands at 5.5 million barrels per day--a buffer that would also erode from the other direction if new oil projects fail to keep up with oil's intrinsic decline rates. In other words, if the situation isn't resolved one way or another within the next year or so, the strategy of containment of a nuclear-armed Iran in a new kind of Cold War could become the only viable option left to us.

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