It is good to see support building in the Senate for this step this week.  But it would be  misguided at best and counter-productive at worst to think we can block Iran’s oil exports without raising global oil prices (and therefore gasoline prices at the pump) on perceptions that oil market “loose” due to slack caused in part by the US supply boom. As noted earlier, this is the argument some advocates of tough oil sanctions, including now Senate Foreign Relations Committee Chairman Menendez, are making.  At a hearing this week on sanctions Chairman Menendez said:  “Oil markets are now and predicted to be loose for the coming year… it would seem that this is the time to press our allies to further reduce crude purchase from Iran.”

Understandably, Congress does not want to do anything that would raise gasoline prices.  If there is a true red line in American politics, driving gasoline prices up is it.  Last year, Congress and the Administration were rudely surprised that financial sanctions caused Iran’s oil exports to drop precipitously, tightening the market and putting upward pressure on oil prices.  They had assumed or hoped Tehran would keep producing and exporting while being forced to heavily discount its sales.  That did not turn out so well.

As Iran gets closer to a nuclear weapons capability, willingness to target oil supplies is going up.  That is a good thing in my view.  But the oil market is not as loose as some interpret from leading oil market forecasts, and even if it were it could tighten later this year before new sanctions went into effect.  If after selling oil sanctions to the public on a forecast that gasoline prices would not rise and they did because the forecast proved wrong or was misunderstood, would that mean we should drop the quarantine option?

A quarantine is called for whether the market is loose or tight because the costs and risks of a nuclear Iran outweigh any risk of near term oil price increases associate with steps to stop it.  We have the tools to mitigate those short term oil price risks – Saudi spare capacity and strategic stocks – and should be prepared to use them.

Below is a wonky note my firm distributed to clients on the subject.  The take-away is that while we should quarantine Iran’s oil exports as a second to last resort before only the worst options are left, we not sell it as cost-free for consumers.  Despite the tremendously welcome US oil supply boom, the global oil market remains tight and fearful, hardly loose.  Forecasts for loosening in the future are just that – forecasts – that depend on many debatable supply and demand trends in the global oil market.

For now and the time being, let’s keep perspective and be realistic about the potential costs of the right policy:  The loss of Iran’s oil is probably the only sanction severe enough to convince Iran’s regime to cease defying the world regarding its nuclear ambitions.  But if implemented this year or next, a quarantine would likely put upward pressure on pump prices.  Instead of pretending otherwise, we can and we should protect our economy by offsetting the loss with higher Saudi production and strategic stock releases.

The Global Oil Market is not ‘Loose’ TRG 130517

However I disagree with the authors’ basing the timing of a halt to Iran’s oil exports on IEA forecasts that the global oil market will be soft in the first part of 2013,  Their logic is reasonable:  A temporarily loose oil market means the world could get by without Iran’s barrels without upward price pressures.  This should reassure nervous politicians with an eye on pump prices.  But there are a couple of problems with conditioning the quarantine strategy on a short term time window based on IEA oil market forecasts:

First, the IEA’s forecast could be wrong and the market may be tighter than it now estimates.  It’s happened before.  Basing critical geopolitical policies on IEA forecasts – or anyone’s forecast – is not sound policy generally and would be a critical mistake in the case of Iran’s nuclear program.

Second, even if the IEA is right that the market is loose now but will tighten up later this year, exhausting sanctions and diplomacy could last well through the summer, possibly after the June 14 Iranian elections.  If the world dawdles while the markets tighten up later this year, would that mean the option of quarantining Iran should not be considered this fall?  I think not….the larger point we agree on still stands:  A nuclear Iran is the worst of all outcomes, for peace, growth and oil prices. As a second-to-last resort before President Obama needs to consider acting on his pledge to use military force, Iran’s oil exports can and should be replaced by higher Saudi production and an IEA strategic stock draw.

Bottom line, quarantining Iran’s oil exports mitigated by higher Saudi production and IEA stock draw makes sense no matter how loose the oil market is.  And while the sooner the better, it should not be discarded later this year if the oil market tightens up.

Iran’s rapidly advancing nuclear program is one of the most acute national security challenges facing the United States, for reasons that are not entirely well appreciated. Whatever else it would portend, an Iranian nuclear breakout would pose first-order challenges to the stability of the entire global economic order via its impact on energy prices, a concern with obvious broad strategic implications.

As policymakers formulate strategies to curb Iran’s nuclear ambitions, the oil market has loomed large, and with good reason. Iran is the third-largest producer in the Organization of the Petroleum Exporting Countries (OPEC), and its location and military capabilities enable it to disrupt up to 17 million barrels of oil per day (mb/d) produced in and exported from the Persian Gulf—roughly 30 percent of the global oil trade. Iran holds a knife across the jugular of the world economy.¹

The Obama Administration’s dual track pressure-and-negotiate strategy has been crafted with the risk of oil price spikes in mind. But its calculations pull up short by considering only the relatively short term. Administration analysts know that a complete embargo on Iranian oil would take 4.6 percent of traded oil off the market at a time when OPEC’s spare capacity is tight, contributing to a bias toward rising oil prices. Washington thus designed oil sanctions so as to keep Iran’s oil flowing into the tight global market while at the same time reducing Iran’s revenues. The plan called on some importers of Iranian oil to reduce or stop Iranian imports and others to demand large discounts as the list of Iran’s customers diminished. Unfortunately, the plan has not worked as intended. Instead of dropping prices, Iran dropped production. The unexpected production drop is due partly to unforeseen constraints on exports arising from problems with tanker insurance, a reduction in foreign investment in Iran’s oil fields, and a policy decision by Tehran to choose lower output over big discounts as the lesser of evils. The U.S. Energy Information Administration has noted that unexpected loss of Iranian supply, among other factors, has contributed to the recent upward pressure on global crude prices. Some of the lost Iranian supply may take many years to return to production, if ever, due to the nature of Iran’s fields. This unexpected loss of supply has made Washington skittish about taking additional steps that could cut Iranian exports still further.

Nevertheless, Iran’s nuclear program remains an important foreign policy challenge, and if diplomacy and sanctions fail to convince Iran to limit its nuclear…

[Ahem....]

Let me clarify for the record:  I have not, do not now, and will not support an explicit price on carbon.  Those who know me, know this.

I do favor SWAPPING our regressive payroll tax for an energy consumption tax as part of a sweeping tax reform and restructuring of our insolvent entitlement programs.

But I would not base the energy tax on carbon, partly because the term “carbon” suggests combating global warming would be the rationale for the tax swap.  In my view the rationale for swapping regressive taxes would not be to combat global warming, but instead to reform our tax code and entitlement programs so we can recover confidence that our children will inherit a solvent, prosperous country.  The swap would also partially insulate consumers from crude oil price volatility.

For this reason, I  would explicitly base the energy tax, again which would go up as payroll taxes went down, on any other unit of measure but carbon.

Substantively and semantically, there’s a big distinction and a big difference.

I realize my tax swap view is controversial and open to legitimate criticism.  But it’s factually untrue and grossly misleading to suggest I favor an explicit price on carbon.  I have asked Inside the Pipeline to correct the record.

But reduced oil imports will not necessarily save us from gyrating pump prices.  Take a look at the chart below showing Norway’s pump prices and global crude prices.  Norway exports oil but its pump prices move with global crude prices, which are set in a global crude oil market that despite US production remains tight and fearful.  As as long as that remains the case, pump prices will remain prone to volatility.  And pump price volatility will continue to roil our economy and politics.

The article was about support for a carbon taxes by some energy companies and Republican economists and thinkers.  The reporter quoted me as saying, in the context of support for carbon taxes,”[t]here’s a silent consensus on this in the country among thinking economists….but it’s considered political suicide.”

This is not my view and not what I said.  I made it emphatically clear to the reporter preparing the article that I saw widespread if quiet support among a broad spectrum of intellectuals and economists for shifting the tax burden from work, savings and investment to consumption when the time comes for serious budget reform.  I specifically clarified my view does not apply to support for a “carbon tax.”

I also made clear I personally favor shifting the regressive tax burden from payroll to fuels  in the context of serious budget reform.  I expressed this  view in a July/August 2011 Foreign Affairs piece co-authored with Michael Levi and in testimony to Congress.  By serious budget reform I mean a major overhaul of entitlement programs, as well as other taxes policies.  I do think it is political suicide to propose such a tax shift before public is willing to support a major budget overhaul, which will unfortunately probably not materialize until our out-of-control fiscal policies precipitate a financial and economic crisis.

More later on my views of the optimal tax shift, but for now I just wanted to correct the record.

Drawing heavily on an essay co-authored with Michael A. Levi in Foreign Affairs, the following recommendations would enable our country to better acclimate to higher oil price volatility, which is driven primarily by structural supply, demand, and spare capacity trends in the global oil market.

First, more reliable data would dampen short-term volatility by reducing uncertainty and facilitate timely investments in production capacity, limiting the amplitude of price extremes over the long term. This is low-hanging fruit, and the priority should be improving OPEC and fast-growing Asian country data.

Second, encourage more supply domestically, in our hemisphere, and around the world. While the United States cannot escape oil price volatility emanating from a global, fungible, and widely traded market, reduced import dependence will strengthen economic resilience to price shocks and diversification of oil production outside the volatile Middle East, and will help reduce the frequency and amplitude of geopolitically driven price swings.

Third, encourage well-regulated but expanded hedging through financial markets. Demand by oil-consuming and producing companies to transfer price risk to those willing to bear it is going to rise. Enact sensible reforms and police against manipulation and fraud, but do not enact blanket restrictions on financial market participants on the mistaken view that they are causing the volatility.

Fourth, resist the temptation to use the Strategic Petroleum Reserves. The SPR and Department of Energy are not well-suited to stabilize global oil prices. Reserves are too small relative to market flows, information is too poor, and SPR interventions would be politicized. If Washington sells SPR every time gasoline prices rise, we will end up with no SPR, more volatile prices, and less protection against severe supply interruptions.

Fifth, elevate the G20 initiative to reduce oil subsidies to make demand more responsive to oil price changes.

Sixth, address the demand side by reallocating public funds currently spent on mature energy technologies toward research and development for alternative technologies at the early stages of development. When the United States finally gets around to serious fiscal reform, taxes on gasoline and diesel should be gradually increased while compensating for those hikes by lowering payroll taxes. This shift would not only discourage consumption while rewarding work; it would also shield consumers from price volatility: if taxes accounted for a larger fraction of the pump price of gasoline and diesel, swings in the underlying price of crude would be less consequential.