Iran, the Strait of Hormuz, and the Ever-Complex Geopolitics of Oil

In a sign that anxiety about oil security of supply isn’t what it used to be, the Group of Twenty (G20) meeting broke up this week with no big joint statements regarding how to protect the freedom of navigation in the Strait of Hormuz. From the sidelines, U.S. President Donald J. Trump said there was “no rush” and “no time pressure” to ease tensions with Iran. German Chancellor Angela Merkel said she advocated “very strongly” to get into a negotiating process on the Iranian situation. Chinese President Xi Jinping noted that China “always stands on the side of peace and opposes war.” The latter statement was a pretty mild one given that approximately one-fifth of the oil that passes through the Strait of Hormuz is destined for China. China has given no public indication that it plans to protect its own shipping. Roughly 60 percent of crude oil passing through the Strait goes to China, Japan, South Korea, and India.

The biggest statement about oil that emerged from the G20 came from Russian President Vladimir Putin who announced at the sidelines that Russia had agreed with Saudi Arabia to extend by six to nine months a deal with the Organization of Petroleum Exporting Countries (OPEC) to restrain oil output to support oil prices. OPEC then announced at its July 2 meeting in Vienna it had agreed to extend the deal for nine months into the first quarter of 2020. In speaking about OPEC’s deliberations, Iran’s oil minister said OPEC was being used as a “tool against Iran” jeopardizing the cartel’s survival. Last year, Iran told other members it was considering quitting OPEC. These various events say a lot about how the geopolitics of oil has changed and the huge implications those changes have for Iran.

A decade ago, countries from the Gulf Cooperation Council (GCC) were of the mindset that they would never let Russia become a member of OPEC. At the same time, Iran was also a major rival to the GCC countries in its overall influence on OPEC outcomes, and both Russia and Iran boasted of their relations with each other in bolstering their respective positions in Mideast regional conflicts. But the new reality is that countries like Saudi Arabia now feel that they can basically ignore Iranian sensitivities at OPEC gatherings and have increased incentive to align with Russia on oil, not only because of the pressing need for revenue but also because of the geopolitical benefits of driving a wedge between Russia and Iran. In turn, Iran may have less to offer Russia as Moscow’s relations with the Arab world continue to improve, except perhaps the possible threat Tehran can make trouble for Russia in Syria or along susceptible pipeline routes. U.S. sanctions against Iran have long been in Russia’s interests to prevent Iranian oil and gas arriving in Europe to compete for its market share. But, Russia has a difficult road to navigate in its relations with Iran and Saudi Arabia since it will want to keep itself an important power broker around many of the Mideast’s current conflicts. This keeps U.S.-Russian interactions on the topic of Iran a challenging one. 

The results of the G20 and subsequent OPEC meetings highlight the bind Tehran is in. What will be its geopolitical lever if oil and gas, which might have provided in years past, is no longer working? The large market surplus of natural gas is working against Iran. Japan’s state firm Japan Oil, Gas and Metals National Corporation (JOGMEC), for example, just signed on to Russia’s Arctic liquefied natural gas (LNG) expansion, in a sign that many countries that might have bought natural gas from Iran are looking elsewhere. The expected rising supplies of U.S. LNG are another. Chinese firms have also slowed new rounds of investment in Iran’s oil and gas sector and are increasingly investing in China’s own clean tech industry instead. Iran has to concern itself with the fact that as the United States, Russia, and oil producers in the Persian Gulf region expand capacity, its own reserves may become more likely to become obsolete or devalued if oil demand peaks over time.

All this raises the question about how a petro-state like Iran reacts to the possible weakening of oil as a strategic tool. Iran will want to show the world that it still has a bargaining chip beyond its own oil resources. Some analysts are suggesting that by boxing it into a corner, the Trump administration might actually incentivize Tehran to lash out to make clear it is too important to ignore in an effort to drive the United States and others to the negotiating table, much the way North Korean missile tests got President Trump’s attention. Most recently, Iran’s response has focused on restarting its nuclear program. Iranian President Hassan Rouhani announced Tehran would return to its previous activities at the Arak nuclear reactor if the remaining signatories to the nuclear deal do not fulfil their promises. Iran might decide to focus on fast tracking its nuclear program to assert itself and gain leverage at a future negotiation. Alternatively, if it gets no geopolitical traction from restarting its nuclear program, Iran could stick with its grey area attacks on energy facilities to make the point it still has hard power to bring to bear. To date, the rules of engagement on cyber warfare against such targets have been harder to establish. A cyber escalation would be a dangerous outcome that would leave the United States with hard decisions about what kind of precedents to set in an active cyber conflict since a large escalation could lead directly to attempted cyberattacks against the U.S. homeland. Oil markets are betting that Iran will not choose to continue to disrupt shipping through the Strait of Hormuz since doing so would clearly escalate into a military confrontation with the United States.

A second possibility, which would require much more diplomacy, is that Iran’s oil woes could prompt its leaders to look at the world with colder realism and come directly to the diplomatic route. One reason that approach could be compelling is that perhaps the real lesson for Iran is not that of North Korea, but of Venezuela whose oil industry is now decimated from years of corruption, lack of financing for maintenance, and an exit of foreign investors. As Mideast oil expert Sara Vakhshouri wrote in a report for the Atlantic Council in 2015, “Most of Iran’s oil fields are old and mature, which means they require further investment and treatments like gas reinjection, in order to maintain current production levels. The country’s oil wells are mostly in the second half of their lives, and are facing continued natural depletion of production capacity at the rate of 8-11 percent per year. It is estimated that Iranian oil fields lose between 300,000 to 500,000 b/d of natural reduction every year due to maturity of fields.”

With its oil exports further curtailed this year, Iran should worry about not only losing market share today (and for however long it takes to restore its position in the global economy), but also the possibility that output drops could cause it to lose productive capacity more permanently if oil fields are damaged from forced production curtailment or reduced spending on maintenance over time.

As Iran can see from its current failure to incentivize relations with Europe, Russia, India, China, and Japan by offering future stakes in its oil sector—a strategy that worked in the past but is apparently no longer effective—time is not on its side when it comes to preserving its future oil and gas sector opportunities.