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Possible Implications of the Iranian Oil Embargo

As efforts continue to impose sanctions on Iran, I thought it would be helpful to discuss the possible implications of these developments for oil-consuming countries.

The most likely outcome of an embargo on oil purchased from Iran is that the countries participating in the embargo buy less oil from Iran while other countries not participating in the embargo buy more oil from Iran ([1], [2]). While this would produce some dislocations, if total world oil production doesn't change, it would have little effect on either Iran or oil-consuming countries, and would basically be a symbolic gesture.

If instead the embargo is successful in reducing the total amount of oil sold by Iran, then the shortfall for global consumers would have to be met by some combination of increased production elsewhere and oil price increases sufficient to bring down global petroleum demand.

As for the first possibility, there appears to be only a limited amount of excess oil-producing capacity at the moment, and certainly far short of the 4.3 million barrels per day that Iran produced in the first three quarters of 2011.

And for the second possibility, it is useful to draw a comparison with previous episodes in which geopolitical events led to production shortfalls from key producing areas. The figure below summarizes world oil production (first column) and oil prices (second column) following 4 dramatic events: the embargo by the Arab members of OPEC following the Arab-Israeli War in September 1973, the Iranian Revolution beginning in November 1978, the Iran-Iraq War beginning in September 1980, and the First Persian Gulf War beginning in August 1990. The loss in production from the affected countries (as a percent of the pre-war world total) is indicated by the dashed line. In each case, there was some offsetting increase in production elsewhere to help make up some of the loss, with the net change in total global production indicated by the solid line. The second panel shows the change in the price of crude oil. At their peak disruptions, these events took out 4-7% of net world production and were associated with oil price increases of 25-70%.

Total World Oil Production
First column: percent change (based on 100 times change in natural logarithm) in (a) total world oil production, and (b) oil production in the impacted countries following each indicated date. Second column: percent change (based on 100 times in natural logarithm) in crude oil producer price index (first entry) or U.S. refiner acquisition cost for subsequent entries. Source:Hamilton (2009).

And each of these events was also followed by a recession in the United States. The table below summarizes the average annual growth rate of U.S. real GDP in the 5 quarters following the above oil price increases. Instead of growing at the historical average of 3.2% per year, U.S. real GDP fell in each case.

Average Growth Rate of US GDP 
Average growth rate of U.S. real GDP (annual rate) over 5 quarters following historical oil shocks. Source: Hamilton (2009).

Although Iran has been getting a lot of attention lately, it's worth remembering that conflict could also easily flare up in either Kazakhstan or Nigeria. Kazakhstan represents about 2% of current world production, which would be about a third a size of any of the four events mentioned above, and similar to the contribution Libya had been making before last year's disruption in that country, which was a key factor in last year's 20% increase in the price of Brent. If all of Nigerian production were to be lost, that would be about half the size the events listed above or 1.5 times as big as Libya or Kazakhstan. By contrast, the loss of all Iranian production would be a comparable event to the four described earlier; indeed, Iran itself figured prominently in 2 of those 4 episodes.

And if an embargo was successful, it is unreasonable to assume that Iran would not try to retaliate in some way. The country has threatened to close the Strait of Hormuz, through which 17 million barrels of oil, or about 20% of total world production, flow each day.

Straight of Hormuz in Oval
Oval highlights Strait of Hormuz. Source: EIA.

As for the likely consequences for oil prices of any supply disruption, the short-run price elasticity of gasoline demand appears to be quite low. Since crude oil represents about half the cost of the retail product, the elasticity of crude oil demand might be expected to be about half of that for gasoline. As a rough rule of thumb, I use a short-run price elasticity for crude oil of 10%. For example, if the lost production were confined to Iran alone, we might expect to see something like a 50% increase in the price of crude oil.

Short Run Price Elasticity
Estimates of short-run price elasticity of gasoline and crude oil. Source: Hamilton (2009).

Some economists have claimed that the U.S. economy is less vulnerable to oil price shocks than it used to be. Close down the Strait of Hormuz, and you'll get a good test of that theory.

By. James Hamilton

Reproduced from Econbrowser

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  • Ferdinand E. Banks on January 17 2012 said:
    Excellent article, but let me ask a question. Why bother to close or attempt to close the Straits of Hormoz? Threatening to close them should have the desired effect, which is to keep the oil price high.

    As for those oil price elasticities, I'm amazed to see that those early elasticities are close to those I estimated when I was in the estimating business. As for the most recent estimates,please forgive me for suggesting that they are probably worthless, now that OPEC controls the oil price.

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