In the wake of the capture of 15 British sailors and marines on 23 March and their subsequent release on 4 April, the world oil market has again focussed in on issues of political risk related to Iran. Benchmark front-month Brent crude oil futures had risen $7 per barrel during the crisis, and have not given up all of this gain. West Texas Intermediate (WTI) was up over $4 per barrel. While the immediate crisis has been resolved, the underlying tension between the West and Iran has not been, and will continue to cause volatility in oil markets through 2007.

On the nuclear issue, escalating tensions through the rest of 2007 will be driven by fundamentally incompatible positions – with the US and Israel, in particular, unwilling to acquiesce in Iranian development of uranium enrichment capability which could allow it to develop nuclear weapons, or at least some sort of 'strategic ambiguity,' and a consensus among Iranian ruling elites supporting the development of these capabilities. The announcement on 9 April by President Mahmoud Ahmadinejad that Iran had begun 'industrial scale' enrichment of uranium almost certainly is an exaggeration of Iran's current capabilities – as they are still about a year away from mastering the technology required to produce high-enriched uranium (HEU) – but reflects the Iranian regimes level of self-confidence as they seek to press home the momentum from what they see as their 'win' in the row over the British military personnel. While Iran is not currently producing weapons grade uranium, it is installing centrifuges in its facility at Natanz at a rapid pace, roughly one 'cascade' of 164 centrifuges per week, which puts it within sight of its goal of installing 3,000 centrifuges by the end of May 2007. It is also possible that, prior to full mastery of the enrichment technology, Iran could begin to stockpile low-enriched uranium (LEU), which could eventually shorten the lead-time to acquisition of enough HEU for a nuclear explosive device once it resolves the final technical obstacles.

The deciding factors

The key decision point is the threshold of Iranian mastery of enrichment technology. For the US and Israel, this is the point at which a decision would need to be taken – either supporting the use of force against Iran to set back its nuclear infrastructure development, or acquiescence. Eurasia Group believes that there is a 60% chance of US and/or Israeli military action against Iran's nuclear facilities by the third quarter of 2008 – much more likely in 2008 than 2007. In the meantime, there will be an escalation in tensions, as the nuclear issue works its way through the process with the UN Security Council and the International Atomic Energy Agency (IAEA). There will probably be more rounds of sanctions as Iran fails to verifiably freeze its enrichment program, but Russia and China will remain opposed to UN Security Council sanctions which would have a real impact on Iran's oil and gas industries.

The perception of an Iranian nuclear arsenal as an existential threat to Israel is very significant, as Israel has an independent capability to mount strikes against Iran. Since air strikes by Israel against Iran would be likely to involve overflight of US-controlled Iraqi airspace by Israeli aircraft, it would need to be coordinated with the US. US reluctance to stand in the way, but also to rely on Israeli capabilities alone, could help tip the balance in favour of military action by the US itself.

In addition to the nuclear issue, there is a potential for miscalculations or incidents leading to escalation in an earlier timeframe. Naval activities in the Persian Gulf, as well as Iranian activities in Iraq, present potential flashpoints which could produce escalation to actual hostilities.

As the Iranian nuclear issue proceeds on a generally escalatory trajectory over the course of the coming year, it will contribute to increased volatility on the world oil market. The 'Iran premium' in oil prices right now is modest – perhaps $5 per barrel – but it is likely to increase as the perception of risk increases. It will not be a steady progression, however, and will probably wax and wane a bit over time.

What price military action?

As for the actual impacts of military action against Iran on the oil market, that would depend in large measure on how vigorous Iran's retaliatory responses were. At a minimum, tankers would not be docking at Iran's Kharg Island terminal during the air campaign and until it was clear that naval hostilities were concluded, which would remove exports of about 2.4 million bpd from the market for a period of a few weeks. If Iran used many of the retaliatory capabilities available to it, however, it could lead to a series of tit for tat responses as the US and Iran exchange a protracted series of blows. That could keep Iranian exports offline for an extended period. Such an extended scenario also could involve a major destabilisation of Iraq, with increased violence between US and British forces and Shia militias. This has the potential to disrupt Iraqi exports as well, which have been running at around 1.6 million bpd. Thus, the total volume offline in such a scenario could easily rise to about 4 million bpd, too much to be made up by current spare capacity, the overwhelming bulk of which is held by Saudi Arabia.

Less probable but higher impact events could include attacks against oil infrastructure in the southern Gulf. Saudi Arabia has a large Shia population in the oil rich Eastern Province, and the UAE has a very large Iranian guest worker population, which potentially leaves it vulnerable to sabotage. With the amount of redundancy built into existing oil infrastructure, and extensive security, it would be difficult to cause a major disruption of production, but even attacks which are not successful in cutting off supplies would increase the perception in the market that a risk of such disruptions exists, and would be likely to have a significant impact on market psychology which could increase the impact on prices.

Lastly, while the much-discussed 'closure of the Strait of Hormuz' for any length of time is not within Iran's capabilities, it is quite possible that Iranian retaliation against shipping could be a factor. Land-based mobile missiles are the largest threat, since they are difficult to locate and destroy, and Iran has an indigenous manufacturing capability for such missiles and an ample supply of them. Successful attacks on tankers could increase the price impact on oil, even if it did not make a large impact on actual volumes.

Greg Priddy is an analyst on global energy at Eurasia Group