Can the United States and the European Union apply sanctions on Iran to curb its nuclear program without boosting oil prices and undermining economies in Asia as well as the West? The answer is particularly critical for Asia because it is has to bear the brunt of the looming sanctions.

China, India, Japan and South Korea must make an unwelcome choice between their energy security and support for international efforts to prevent the spread of nuclear weapons.

In doing so, they have to factor in the impact of their choices on price of oil. Brent crude oil, an international benchmark, has recently traded at over $123 a barrel for April settlement, up from $107 a barrel at the start of the year, but below the record high of $147 set in mid-2008.

Geopolitical tensions stemming from the U.S. and EU sanctions against Iran are largely responsible for keeping the oil price high amidst sluggish growth in the West and a slowdown in Asia. Indeed, some energy traders say that the rise in world oil prices has more than compensated Iran for any losses in oil export volumes caused by the sanctions.

It is therefore in Iran’s interest to stoke the crisis by warning it may block oil tanker shipments through the Strait of Hormuz and threatening retaliation against countries that support sanctions or offer to make up any oil supply shortfall from Iran. The Hormuz Strait is the only way by sea from the energy-rich Persian Gulf.

On Feb. 19, Teheran halted oil exports to Britain and France, which have been leading the push for a tougher policy to stop uranium enrichment in Iran.

Western governments have concluded that Teheran has a clandestine program to achieve nuclear weapons capability. Iran denies this.

Iran has been exporting about 2.5 million barrels of crude oil per day (bpd), with 65 percent going to Asia and 30 percent into Europe. It is the second largest oil producer after Saudi Arabia in the Organization of Petroleum Exporting Countries (OPEC).

The sanctions are intended to curtail Iranian oil sales, which finance more than 50 percent of the national budget and account for 80 percent of export income. The new U.S. sanctions take effect for oil-related transactions on June 28. The EU has said it will end oil imports from Iran and freeze Iranian central bank assets from July.

The advance notice is to give Iran’s major oil customers in Asia and Europe time to find alternative suppliers, and thus avoid driving prices higher. U.S. allies Japan and South Korea are negotiating with Washington to reach an acceptable reduction in their Iranian oil purchases to avoid the sanctions.

India and China, which together buy 34 percent of Iran’s oil, appear reluctant to yield to Western pressure, arguing that the U.S. and EU sanctions go beyond measures approved by the United Nations Security Council and will be counterproductive.

Still, the International Energy Agency said in a recent report that up to one million barrels of Iran’s 2.5 million bpd in exports may be replaced by alternative supplies once the EU sanctions take effect, forcing Iran to put unsold oil into floating storage or cut output in the second half of the year.

The world oil market is being stretched to the limit, despite a faltering economy and modest gains in oil demand led by China and India. IHS CERA, a leading international energy consultancy, expects oil demand to increase by just 700,000 bpd in 2012, well below the average of 1.1 million bpd per year in the last decade.

Yet worries abound over another possible oil shock in the Middle East as the U.S. and Israel refuse to rule out military action against Iran’s nuclear facilities. IHS CERA estimates that there is between 1.8 million bpd and 2.5 million bpd of effective spare oil production capacity in the world — all of it concentrated on the Arabian Peninsula within range of Iranian ballistic missiles.

This is only a small shock absorber for the oil market. It is equivalent to between 2 percent to 3 percent of global oil demand. As recently as 2010, spare capacity was much higher, around 5.5 million bpd. “Geopolitical fears have a more pronounced impact on oil prices when spare capacity is low — as it is today,” James Burkhard, IHS CERA’s managing director told a congressional panel in Washington on Jan. 31.

Iran recently offered to restart negotiations on its nuclear program with Western nations, Russia and China. Whether this is a serious attempt to resolve the issue or another move to buy time, remains to be seen.

Meanwhile, the oil market and major Asian oil importers are hoping for the best while preparing for the worst.

Michael Richardson is a visiting senior research fellow at the Institute of South East Asian Studies in Singapore.

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