Excerpts from a report by Thomas McNaugher and William Quandt of the Brookings Institution, published on May 14, 1984 by Cambridge Energy Research Associates. These excerpts appeared in Arab Oil and Gas (Paris), June 1, 1984.
The Iran-Iraq war is reaching a critical phase. As a result, there is more of a chance today than ever before that a major change in the war is at hand. This could have both major consequences for the flow of oil in the near term, and broader implications for power and influence in the region over the longer term. Although we are not yet convinced that the Iran-Iraq war threatens a major disruption in the flow of oil, the odds are beginning to change in the direction of greater danger for Western interests — meaning that the threat to the world oil market could become larger in this new phase. But the gravest threat could come not during the war itself but from the outcome of the war.
Because of the oil cushion that exists around the world, any disruption brought on by the conflict would probably be limited in size and duration. Those who build up inventories in the heat of the moment, as in 1979, would probably find themselves stuck with high-priced stocks. The oil market could, however, be decisively changed by an out-and-out Iranian victory, which would make Iran the dominant influence on production — and on production decisions — in much of the Gulf region. This could reduce the range of available capacity for world oil supplied in the rest of the 1980s and into the 1990s, and make an Iranian-dominated coalition the swing supplier in OPEC….
The Iran-Iraq war has already resulted in a disruption of the flow of oil, but prices have not been significantly affected and therefore much of the world has not reacted with alarm. In this sense, the oil shocks of the 1970s are not necessarily a good guide to the 1980s. It will now take a much larger disruption than any we have known to send prices to new levels and to keep them there. The Iran-Iraq war is still, however, the most likely catalyst for such a development. Several outcomes to the war are conceivable, and each has different implications for the long-term price of oil.
Scenario One: Balance of Power
The Iran-Iraq conflict may play itself out in such a way that a rough balance of power is established [between] these two Gulf powers, with Saudi Arabia as the third important player in the regional game. In recent times, Saudi Arabia has supported Iraq, but the logic of the Saudi position is to try to prevent the hegemony of either Iran or Iraq. This three-sided power balance has within it the potential for shifts of alignment.
For OPEC, a stalemated Iran-Iraq conflict, with competition among the three big oil producers of the Gulf, is a prescription for organizational weakness. It will be extremely difficult to develop any consensus on oil policy among Baghdad, Tehran and Riyadh. Oil-market shares will be one of many topics in dispute. The stakes are large and the economic needs of each party are substantial. No one of the three Gulf powers will hold back production for long if the others are aggressively seeking a larger market share. If the current round of fighting comes to an end, Iran and Iraq will both seek to increase exports, probably at Saudi expense. In this scenario, downward pressure on prices could be expected.
Scenario Two: Iranian Hegemony
A second outcome of the Iran-Iraq war, probably less likely than the first, is a decisive Iranian victory in southern Iraq, which would establish Iran as a hegemonic power in the Gulf. If Tehran could consolidate its position, it would have a strong voice in the political and economic decisions of its neighbors. This could mean that Iran would influence decisions affecting a large proportion of the oil produced in the Gulf. In periods of soft demand, Iran might pressure Iraq and Saudi Arabia to keep production low. The closer this outcome approximates an Iranian monopoly of power, the easier it will be to keep oil prices high by manipulating the supply side of the market. The competitive pressures that would be felt in the first scenario would be measurably reduced in circumstances of Iranian hegemony. An Iranian-dominated coalition would thus become the swing producer for OPEC. Most of the world’s spare capacity would be at its disposal.
Scenario Three: Continuing Attrition and Oil Disruption
A variant of these first two outcomes would be a continuation of the Iran-Iraq war, with Iran in a strong position but without a clear-cut victory. In these circumstances, there would be recurring danger of oil disruptions of moderate size. These could result from successful Iranian or Iraqi strikes at sensitive targets — Kharg island, tankers, oil facilities, pipelines — and for short periods some oil would be unavailable to customers. Since large amounts of oil are available elsewhere, adjustments could be made without much impact on price. But customers would not react only to the immediate loss of oil, which might be small. They would be making judgments as well about future availability of Gulf oil.
It is the uncertainty surrounding any disruption of oil supplies from the Gulf that can add to the price effect. If one could be sure that an Iraqi strike on oil tankers were essentially a one-shot affair, oil markets would not register much of a reaction. But if an attack were seen as the opening phase of a sustained military campaign that would affect oil supplies for a long period, the market reaction would differ. From this perspective, expectations will have a strong bearing on stock usage. US government policy on use of the Strategic Petroleum Reserve will also affect calculations in periods of uncertainty associated with small disruptions. From our analysis of the political and military situation, it seems most likely that any disruptions of oil supplies as a result of the Iran-Iraq war would be limited in size and duration. Spare capacity elsewhere in the world, plus strategic stocks, could be used to make up for lost oil. The prospect of a blockade of the Strait of Hormuz or a successful Iranian attack on Saudi oil facilities seems relatively low, and these are the only large-scale disruptions that would entail major price effects. Those who gamble on a sharp and sustained rise in prices may find themselves with high-priced stocks on hand when the disruption is over.
The Greater Danger
The most difficult oil-supply problem for the world to deal with would not be the small disruptions resulting from the continuing Iran-Iraq conflict. Market forces, and military capabilities, would help keep prices in line. The greater danger would come from an Iranian victory. Oil would doubtless continue to flow from the Gulf, but Iran would have considerable influence over the terms on which it was made available. In time, political changes might take place on the Arab side of the Gulf. Conservative Islamic regimes might be hostile to the West, and foreign technicians might be asked to leave. Oilfield maintenance could decline. Spare capacity might be reduced. Oil prices might not immediately be affected, but the stage would be set for oil shocks later in the decade when demand for Gulf oil is likely to increase.
In brief, from the perspective of the oil market, the danger inherent in the Iran-Iraq conflict is not so much the threat of occasional disruptions in current supplies. It is, rather, the danger that an Iranian victory would fundamentally change the nature of the Gulf oil supply system of the late 1980s. It is the prospect of future oil shocks growing out of conditions set in place by an Iranian victory in the battle for Basra that should concern us. By contrast, the short-term picture is considerably less alarming, and the most likely scenario of prolonged stalemate probably helps insure relatively soft oil markets for the next few years.