How Iran Could Affect Your Wallet in 2012

Four scenarios for how a showdown over Iran's nuclear program could affect oil and gasoline prices.

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The economy might make a tangible comeback this year, with much-needed gains in hiring, the beleaguered housing market and long-depressed consumer confidence.

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Or, there could be a financial shock that triggers another recession. For months, investors have worried about a European financial crisis that spreads to America. But now there's a fresh concern: Iran, which is threatening to disrupt the world's oil markets and perhaps even start a new war in the Middle East.

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With its belligerence toward Israel, its sponsorship of terrorism and its despotic leaders, Iran has been a thorn in America's side since the 1970s. But a fresh confrontation is now simmering as western leaders try new tactics to pre-empt Iran's quest to obtain nuclear weapons. Intelligence experts say Iran could get the bomb in five years or less, and a recent international report found worrisome progress in Iran's nuclear program. Those findings create a premise for tougher coordinated action to contain Iran's nuclear ambitions, which the United States and Europe and now pursuing.

President Obama recently signed a law that could essentially prevent Iran, the world's third-biggest oil exporter, from selling oil to many of its usual customers. Europe is preparing to enact its own embargo on Iranian oil. There's wiggle room in terms of how strictly these new rules will be enforced, but if fully enacted, they could devastate Iran's economy, since oil exports bring in about $75 billion per year—nearly 20 percent of Iran's total GDP. They could also push oil prices higher, with gasoline prices cresting $4 per gallon at American filling stations and perhaps even approaching $5.

In response to the western threats, Iran, with customary bombast, has threatened to shut down the Strait of Hormuz, a choke point through which 20 percent of the world's oil flows every day. It has also warned the U.S. Navy to stay out of the Persian Gulf. Such threats are nothing new, but the stakes are rising as Iranian nuclear capability comes closer to reality.

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Oil prices, which have hovered around $100 per barrel recently, may already reflect a $10 to $20 "fear premium" based on rising odds of an oil shock. If shooting breaks out, prices could easily hit $150 per barrel, at least for a while. On the other hand, fears of a war with Iran might be overblown, since Iran itself might suffer the most. "Iran has more to lose if its oil is cut off than the world has to lose," says Mohsin Khan, a senior fellow at the Peterson Institute for International Economics. "The world could adjust. Iran could not adjust."

Here are four scenarios depicting how the confrontation may play out over coming months, along with rough guesses of how likely each scenario is:

1. A shooting war initiated by Iran. There's no shortage of war-gaming on how a military showdown with Iran would proceed, much of it by armchair strategists. Iran's navy is capable of mining the Strait of Hormuz and harassing oil tankers or enemy warships with armed speedboats, missiles and perhaps submarines. But a sustained blockade of the strait is a stretch, and hostile provocations by Iran would likely bring an overwhelming response from the U.S. Navy and allied forces, with Iran suffering brutal losses.

At most, Iran might be able to disrupt oil shipments in the Gulf for a few weeks, although that might alienate important customers like China and make them more inclined to support global efforts to isolate Iran. If Iran initiated hostilities, it would also create a pretext for U.S. or allied strikes on Iran's nuclear facilities.

Probability: Unlikely. The United States is unambiguous in its commitment to keeping oil flowing through the Persian Gulf, and Iran knows it would lose big if it got into a shootout with the world's only superpower.

Economic impact: Temporary panic. Economists think the peak price for oil in a shooting scenario is about $150 per barrel—with gas spiking to perhaps $5 per gallon. But it would be in the Obama administration's interest to end an oil standoff as quickly and decisively as possible, which is probably what would happen. Oil prices might then fall back to $100 per barrel or lower.

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2. Pre-emptive attacks against Iran's nuclear facilities. These could be carried out by Israel or a U.S.-led coalition but could also backfire by making Iran look like a victim of western aggression. Iran could retaliate militarily, leading to the same type of outcome as in the first scenario. It might also resort to terrorism or assassination attempts, as it has done before.

Probability: Possible. The United States and Europe seem to be doubling down on sanctions for now, but that's no guarantee that Israel—a presumed target of Iranian missiles—will show military restraint. The longer Iran is able to withstand sanctions and continue developing nuclear weapons, the more likely military strikes become.

Economic impact: Less than it might seem. Military strikes against Iran would be a bold and risky move, but after a brief bout of panic, oil markets might quickly return to normal. Iran can't afford to pull its oil from the global market, and if western powers initiated strikes, protecting oil shipments through the Strait of Hormuz would be a top priority. In the aftermath, oil prices might even fall from where they are now, since there might be little or no need for sanctions if strikes damage Iran's nuclear program. Iran would roar with indignation but might tacitly welcome the ability to freely sell its oil again.

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3. Lasting sanctions. Iran produces about 4 million barrels of oil per day, with about half of that exported for sale in the global market. So if sanctions completely shut down Iran's oil exports, the world's daily supply would shrink by about 2 million barrels, or roughly 2.3 percent. That's about one-third more than the oil lost when Libyan production went offline in 2011—which pushed prices to a peak of about $113 per barrel.

Probability: Likely. Sanctions will most likely be far from airtight, however, so Iran will probably continue to export some oil. Still, sanctions could cut into Iran's oil revenues enough to upset the economy and destabilize the leadership, which is basically the objective.

Economic impact: Elevated oil and gasoline prices for a while. The White House says it can manage sanctions on Iran without forcing oil and gas prices up, with Saudi Arabia, for example, pumping more to make up for part of the shortfall. But fear of a military conflict, combined with aggressive bidding by speculators, could still drive prices up, and may have already. Obama has one trump card: America's strategic petroleum reserve, which contains about 700 million barrels of oil. If Obama released just a small portion of that into the market, it would signal U.S. determination to push prices down, and would probably be effective.

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4. Capitulation by Iran on its nuclear program. Iran probably wouldn't announce it, but it could change its policies and suspend its nuclear program. There could also be a change in regime, with new leaders renouncing the nuclear program and getting along better with the west. That would probably require a bloody revolution, however.

Probability: Possible. There's no sign of an imminent revolution in Iran, but most experts also failed to foresee the "Arab Spring" that led to the ouster of authoritarian leaders in Tunisia, Egypt, and Libya in 2011, and now threatens Syria's dictator. Iranian parliamentary elections are scheduled for March, and could trigger uprisings such as those that accompanied the 2009 presidential election.

Economic impact: Rising, then falling, oil prices. Fresh signs of an Iranian revolution would spook oil markets, but if the Iranian nuclear standoff is resolved, the fear premium on oil would subside. Oil prices still seem likely to drift upward over time, however, as the world economy grows, demand strengthens and the cost of extracting oil goes up.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success , to be published in May. Follow him on Twitter: @rickjnewman

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