Hans Blix: "Why not in Iran too?

Former UN arms inspector Hans Blix has an op-ed piece in today’s International Herald Tribune, in which he criticizes the US approach toward Iran’s uranium enrichment program. Blix points to the recent six-party talks and recent agreement with North Korea, and asks “Why not in Iran too?”

The answers to this question are many and obvious.

Iran sits atop the world’s second largest proven reserve of oil and the second largest reserve of natural gas. It derives significant revenues from the export of oil (though it needs to import both gasoline and natural gas), and the government derives roughly 85% of its budgeted revenues from the sale of oil. The Iranian people are relatively well off.

On the other hand, North Korea holds off mass starvation only through the good graces of China, which provides North Korea with about 70% of its food imports and more than 70% of its oil imports. As a result, North Korea is affected more by the threat of economic sanctions than is Iran. No country has the sort of leverage with Iran that China has with North Korea.

Iran has strategic influence over much of the oil-rich Middle East, and the US has active military engagements in two countries bordering Iran. The Israelis have just fought a battle in Lebanon with Iran’s proxy, Hezbollah, and Iran actively supports Hamas, which refuses to recognize Israel’s right to exist, and which has been battling the Fatah party for control of the Palestinian administration. Iran has been sending Revolutionary Guards and intelligence officers into Iraq, and it appears as if Iranian weapons have found their way into Iraq and are being used against US troops. Iran clearly has a number of ways in which it can make life difficult to varying degrees for the US.

The primary threat posed by North Korea to American interests is the ability of North Korea to destroy Seoul and to eventually threaten Japanese cities. Of course this capability poses a very significant threat, but it’s difficult to use this threat to gain a tactical advantage in negotiations. If Pyongyang were to move against Seoul, presumably North Korea would come under withering attack that would lead to the removal of Kim Jong Il and lead to a tremendous exodus of refugees. Whereas Iran can ratchet tensions with the West by discrete amounts and gauge Western reaction, the North Koreans have only continued recourse to the threat against Seoul.

Of course there are many more differences between Iran and North Korea, including the religious motivations of leadership, distinct regional ambitions, different political systems, and radically different historical experiences with the US. But in some sense, all these differences are beside the point. The real answer to Blix’s question, “Why not in Iran too?” is that the approach taken with North Korea has been an abject failure.

The Agreed Framework reached with North Korea by the Clinton administration did not stop its plutonium projects, and the North Koreans haven’t even disclosed their uranium projects. And of course the North Koreans tested their first nuclear bombs a few months ago. By any stretch of the word ‘success’ the negotiations with North Korea have not been successful.

In recent years, India, Pakistan, and North Korea have all developed nuclear weapons, and have paid very little price for having done so. I believe Iran has learned from their experience and will continue developing nuclear weapons and will pay a similarly small price in return.

What about a military strike against Iranian nuclear facilities? It’s true that in 1981 Israel bombed and crippled Iraq’s Osiraq reactor, which was later completely destroyed by the Americans in the first Gulf war. (Iran first bombed this facility in 1980 at the outbreak of the Iran-Iraq war.) But analysts believe the major elements of the Iranian program are buried deep underground. My understanding is that conventional weapons are unlikely to cripple these facilities. While there have been some reports that the US or the Israelis are planning to use tactical nuclear weapons against these facilities, I remain highly skeptical.

Were the US to use even limited tactical nuclear weapons, the condemnation throughout the world would be deafening. US interests in most parts of the world would suffer extraordinary setbacks, representing a tremendous cost. I can’t imagine a scenario in which US strategists would consider the cost worth paying in order – at beast – to temporarily postpone Iran’s nuclear weapons program.

What about the Israelis? Might they use tactical nuclear weapons against Iran? I don’t believe Israel wants to be the second nation to use nuclear weapons, but many people in Israel believe the country is facing an existential crisis. Were it to use tactical nuclear weapons against Iran, it could expect missile attacks from Iran, withering rocket fire from the Palestinians, possible military retaliation from Syria, and a resounding denunciation from governments the world over. Further, the move would risk further destabilizing Iraq, possibly destabilize Pakistan (now a nuclear nation), and might prompt the Saudis and Egyptians to pursue nuclear weapons of their own.

None of these scenarios are pleasant. But in the end, I believe that there are really only two scenarios with much likelihood at the moment. Either Israel employs tactical nuclear weapons to cripple Iranian uranium enrichment facilities, or the world needs to reconcile itself with a radical Islamic revolutionary government possessing nuclear weapons.

A Natural Gas Cartel Involving Russia and Iran?

Iran recently renewed a proposal to create an OPEC-style cartel for natural gas, to include Russia and Qatar. Vladimir Putin has expressed interest in this idea in the past and has recently expressed interest in discussing the idea further.

As has been reported in much of the financial press, the creation of a natural gas cartel is problematic for a few reasons.

1. 
   Natural gas is more difficult to transport than oil. Gas is typically transported through fixed pipelines and is typically sold via long-term delivery contracts rather than on a spot market. As such, the manipulation of supply to control price is problematic. Liquefied natural gas facilities are being built to ship gas, but the planned facilities are scarce and are likely to remain scarce for the foreseeable future.
   
2. Despite having vast gas resources, Iran still imports natural gas for its own use, though the Iranians would like to become major exporters in the future.
   
3. Russia has not been interested in joining OPEC, primarily because it wants to follow an independent energy policy. And Putin has said already that Russia would not be willing to adhere to natural gas supply quotas.
   
4. Qatar is a firm ally of the US. It has no interest in antagonizing the US by forming a gas cartel with Russia and Iran. In fact, Qatar has expressed disinterest in forming a gas cartel, preferring instead to focus discussions via the Gas Exporting Country Forum – a toothless group created in 2001.
   

Given that Iran doesn’t presently export natural gas, that Russia refuses to adhere to supply quotas, and that Qatar continually expressed disinterest, why are the Iranians and the Russians expressing interest in this idea again – and why now?

In its drive toward regional hegemony in the Middle East, Iran is embroiled in multiple disputes with the US – particularly the issues of its uranium enrichment program and its sponsorship of Hezbollah in Lebanon and Hamas in Palestine.

Given its imbroglios in Iraq and Afghanistan, the US is confined largely to diplomatic efforts to constrain Iran. And given that the EU trio of Britain, France, and Germany have failed in their diplomatic efforts to constrain Iranian nuclear ambitions, the US is increasingly looking toward the UN. By discussing the creation of a natural gas cartel, Iran and Russia are reminding the US that Iran has an ally on the Security Council – a friend anxious to use its veto to thwart US ambitions, particularly in light of Putin’s hostile speech given February 10th at the Munich Conference on Security Policy.

Russia is unwilling to support a program of economic and political sanctions with potential to motivate Tehran to abandon its nuclear weapons goals. For that matter, neither is France – as seen by Chirac’s unguarded and widely-reported remarks to the International Herald Tribune during an interview on January 29th.

Might China play a constructive role in deterring the Iranian nuclear program, similar to the role it played in securing the recent agreement with North Korea? Not likely. China’s own drive toward hegemony in Asia requires China to demonstrate that it can exert control in the region, and North Korea’s testing of a nuclear device last October was an embarrassment for China. As a result, China felt compelled to act to secure North Korea’s agreement. No such motivations exist for China in relation to Iran, and Washington can expect no help from Beijing in securing a similar agreement from Tehran.

As a result, I believe there is no diplomatic route to thwarting Iran’s nuclear ambitions. In this case, either a limited military strike is used in an attempt to stop Iran’s nuclear program, or Iran will acquire nuclear weapons. Either way, the Middle East is likely to become less stable, with consequences for the price of oil, inflation, corporate profits, equity markets, and bond markets. But at least we won’t also be worrying about a natural gas cartel.

Oil, the Fed, and the ECB

The International Herald Tribune today published an article discussing the fact that oil prices decreases are putting pressure on both the Federal Reserve and the ECB to hike rates still further – an interesting argument given the different perspectives of these central banks.

While oil prices were reaching highs of around USD 77 per barrel in 2006, the Fed was downplaying the increase in the headline inflation indices and focusing on the fact that higher oil prices acted as a tax on consumers, which would slow the economy and relieve pressure in measures of core inflation. On the other hand, the ECB was highlighting the risks posed by increases in headline inflation – particularly the risk that the higher headline numbers might result in an increase in the inflation expectations held by labor unions and business leaders during wage bargaining rounds.

Now that oil prices are decreasing, the Fed is expressing concern about the oil’s impact on the economy and the risk that core inflation readings will move higher – consistent with their model of the economy and their general focus on core rather than headline inflation measures.

The ECB appears to be less consistent in its treatment of oil price moves these days. ECB members are highlighting upside risks to core readings for a change – ignoring the downward pressure on headlines measures – and also pointing to possible second-round effects of past oil prices rises.

Is the ECB being intellectually inconsistent – perhaps because of its desire to move rates higher regardless of the economic environment?

In my view, the key driver for the ECB for some time now has been their concern over M3 growth within the eurozone. M3 was growing too quickly for the ECB as oil prices were increasing – and recent data show it growing even more rapidly now. The ECB is one of the most monetarist of central banks, and the market has repeatedly underestimated the concern that ECB members have with rapid money and credit growth.

I attended a dinner with Trichet in New York a few months ago, and I was impressed by his focus on money and credit growth – particularly private credit. More important, he noted that he was surprised that the market hadn’t really appreciated the ECB’s focus on this issue.

A decrease in the price of oil should help to further stimulate the growth in credit components within the eurozone – adding to the ECB’s concerns about inflation over the medium-term. For this reason – more than concerns they have about GDP growth per se or second round effects of previous oil price increases – the ECB is expressing concerns about recent oil price declines.

The transmission mechanism by which the ECB sees oil prices as having an impact on medium-term inflation is money and credit growth, and I continue to believe that the key to forecasting ECB policy this year is forecasting the growth of money and credit balances within the euro area – and anticipating the ECB responses to those increases.

Saudis using oil to constrain Tehran?

The front page of today’s WSJ Europe had an interesting article entitled, “Can Russia, Iran endure oil pinch” highlighting the difficulties that the governments in Russia, Iran, and Venezuala are facing with oil down from a high of around USD 77 in August. More interesting, today’s International Herald Tribune contains an article entitled, “Saudi Arabia’s cryptic signals,” (from yesterday's NY Times) with a key passage:

Oil traders have been buzzing in recent weeks about whether Saudi Arabia was actively seeking to depress oil markets in the hope of crippling the Iranian economy, as a Saudi analyst — albeit not one from the government — suggested in an opinion article in The Washington Post last year. The Saudis quickly dismissed the suggestion, but given the tensions in the Middle East, oil and politics remain closely linked.

Though not reported in the NY Times article, the analyst in question, Nawaf Obaid, was the director of the Saudi National Security Assessment Project in Riyadh, an adjunct fellow at the Center for Strategic and International Studies in Washington, and a consultant to the Saudi Embassy in Washington. After publishing the article in question, Prince Turki, the Saudi ambassador, terminated the embassy contract with Obaid, ostensibly to distance himself from the policy outlined in the article.

The buzz is that the former Saudi Ambassador and long-time friend of the Bush family, Prince Bandar, is advocating the policy outlined by Obaid in the Washington Post article: namely that the Saudis will fund the Iraqi sunnis in the event of a premature US withdrawal from Iraq -- and also that the Saudis will increase the supply of oil on the market in order to push the price low enough to hurt the Iranians and to limit their ability to fund the Shiite insurgency in Iraq and Hezbollah in Lebanon. It's understood that Prince Turki advocates another policy – one involving a regional dialogue to include the Iranians -- and that his resignation was in protest to Bandar’s continuing contacts with the US Administration. (Bandar and Turki are both said to be maneuvering to replace Turki’s ailing brother, Prince Saud al-Faisal, as Saudi Foreign Minister.)

Besides Saudi efforts to pressure Iran, there are of course numerous other reasons offered for the decrease in the oil price since August of last year, including:

• A milder-than-expected hurricane season in the Atlantic;
• Milder-than-expected December temperatures in the northeastern US and in Europe; and
• Oil exporter concerns over the investment in alternative energy.

Also mentioned have been global slowdowns in the US and in China, but recent data suggest growth has actually been more robust than had been expected in both economies.

My longer-term expectation had been that oil prices would decline from their highs, as oil producing nations try to head off the large investment that could help develop alternative energy sectors. My understanding was that this hadn’t taken place yet because years of underinvestment had left the Saudis and others with little ability to dramatically increase production. In that light, my near-term expectation was that oil prices would increase as global growth continues apace.

But recent articles about the Saudis moving to increase production so as to lower the oil price and cripple Iran have given me cause to reconsider. If the Saudis have been able to increase production – and have an ability to increase production still further – their interest in restraining Tehran and in slowing the growth of alternative energy sources are two good reasons for them to attempt to engineer still further price declines.

So – a few key questions to research:

• Have the Saudis increased production by a meaningful amount in recent months?
• Do they have the ability to increase production significantly going forward?
• Which Saudi faction will win the debate about Middle East policy, particularly as it pertains to the use of oil prices as a lever vis-à-vis Iran?
  

The answers to these questions may be as important to discerning trends in oil prices these days as any analysis of the demand side.