By Javier Blas, Commodities Editor

When Ronald Reagan imposed an embargo on Iranian oil in October 1987, the market braced itself for a big price hike. But while the ban stopped the flow of 500,000 barrels a day to the US, crude prices fell from about $20 a barrel in early October of that year to less than $15 in December.

There was a simple explanation: instead of cutting output, Tehran re- directed oil usually sold to the US to other markets.

A quarter of a century later, the energy market finds itself in a similar situation. This time, however, the combined impact of US sanctions and forthcoming European Union sanctions on Iran?s oil industry could force Tehran to cut production, potentially causing the price of oil to soar, as well as damaging the Iranian economy.

Washington has introduced sanctions to penalise foreign financial institutions dealing with Iran?s central bank, which clear most oil exports, and Brussels will discuss an embargo on Iranian crude to Europe on January 23.

The EU embargo will hit 450,000-550,000 barrels a day of Iranian exports. The impact of the US sanctions is unclear, but Japan, South Korea, Taiwan and India could reduce, even if only slightly, their purchases of Iranian oil, affecting up to 250,000 b/d, according to oil traders and industry chiefs.

?As much as 550,000-850,000 b/d of Iran?s oil exports could be impacted, or between 25 and 35 per cent of the country?s exports,? said Ed Morse, head of commodities research at Citigroup and a former US energy official.

Until now, the dominant theory in the industry was that the sanctions? impact would be muted, based on the precedent of the 1987 US embargo. But more people are now suggesting that Tehran will struggle to resell its oil.

Michael Wittner, an oil analyst at Soci?t? G?n?rale and a former CIA official, believes that Iran will be able to sell only 200,000-300,000 b/d to the Chinese and other refiners.

?Iran would get hurt from lower revenues, due to both lower volumes and forced price discounting,? he said.

David Goldwyn, a Washington-based consultant and until recently the US state department?s top diplomat for energy affairs, said: ?I don?t think Iran would be able to resell all the oil that European and Asian clients are going to stop buying?.

Tehran has a limited roster of current clients. Besides the EU, it sells its crude only to China, India, Japan, South Africa, South Korea, Sri Lanka, Taiwan and Turkey.

Of those nations, Japan, South Korea and Taiwan, which import on average 341,000 b/d, 244,000 b/d and 33,000 b/d respectively, are close allies of the US and are more likely to reduce their purchases rather than increase them.

Although Tokyo, Seoul and Taipei will continue to buy Iranian oil, they are likely to cut purchases at the margin, thus forcing Iran to find a home for some of its output.

India, which buys on average 330,000 b/d of Iranian oil, is in a similar position. New Delhi has already cut back on Iranian oil as domestic refiners struggle with payments due to the impact of previous US financial sanctions. Further cuts are now likely as the current payment channel – through Turkey?s Halkbank – is at risk because of Washington?s latest round of sanctions.

Among Iran?s other current clients, Sri Lanka is importing almost all its oil from Iran using a generous interest-free credit facility, leaving Colombo with no room to boost its imports of 39,000 b/d. Turkey and South Africa are also big buyers – 182,000 b/d and 98,000 b/d respectively. But as Iran already accounts for a third of their total oil imports, they are unlikely to buy more to maintain their energy security.

That leaves China. Beijing is already the world?s largest importer of Iranian oil, buying 540,000 b/d last year. Traders and analysts think it could step up purchases. Yet buying all the oil that Tehran presently sells to the EU and some token amounts from other Asian countries would boost its reliance on Iran by more than 100 per cent.

Even so, Jeffrey Currie, head of commodities research at Goldman Sachs, says that China would buy Iranian oil to fill up its strategic petroleum reserve. The view is shared by oil traders, who believe that Tehran would offer large discounts to Beijing. ?The only question is about price,? says a Geneva-based senior oil trader.

If current clients do not offset the big loss of the European market – and potential cuts among US allies in Asia – Tehran could try to look for new buyers, or dust off old ones, such as Pakistan.

But the impact of Washington?s latest financial sanctions is likely to prevent most new clients from paying for the oil. More?over, few emerging countries have the sophisticated refineries to process the low-quality Iranian oil into high-demand products such as petrol.

? The Financial Times Limited 2012