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(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, Dec 6 (Reuters) - Oil markets remain relaxed while a significant diplomatic and military effort is clearly under way to raise the pressure on Iran's government to abandon its uranium enrichment programme.
Markets have not moved despite the risks that conflict could escalate between Iran and western countries or that the EU could ban imports of Iranian crude.
Prices for Brent crude futures expiring in February and March, which would be the first impacted by any embargo, continue to trade below $110 per barrel, well below the previous high in October, let alone the peak set in April.
Implied volatilities for Brent call options are modest and more than 10 percentage points below equivalent downside puts. The strong downward skew, which has been in place since the summer, suggests the demand for protection against a fall in prices still outstrips anxiety about a price spike.
Media reports about sanctions and the "war in the shadows" remain confused, in part because of extensive spinning by foreign ministries across Europe and the United States. But it is clear there has been a substantial intensification of efforts to delay or derail Iran's enrichment programme.
Tensions have come close to boiling point after the storming of Britain's embassy in Tehran. The conflict is close to emerging into the open. Or to use an old analogy, the cold war has come close to turning hot.
What is less certain is whether the crucial policymakers in either western capitals or Tehran think the time is ripe to escalate further, or intensify sanctions, and risk a military confrontation.
Warlike rhetoric has certainly ratcheted up in the past two months, mostly as a result of a series of leaks in Israeli media. However, on Dec. 2, U.S. Defense Secretary Leon Panetta issued his strongest warning yet about the need to avert uncontrolled escalation.
He warned Israel against launching a strike on Iran's nuclear facilities. Panetta said it risked "an escalation" that could "consume the Middle East in confrontation and conflict that we would regret"..
Panetta's public admonition backed up a warning he reportedly delivered in private to Israel's defence minister, Ehud Barak, last month - including a warning about the impact a strike would have the on the world economy.
The risk of a strike remains shrouded in strategic ambiguity.
In what appeared to be a significant de-escalation, Barak told Israel Radio last week, "We have no intention, at the moment, of taking action, but the State of Israel is far from being paralysed by fear ... It must act calmly and quietly -- we don't need big wars."
But all options remain open. Barak noted that the government of Israel "greatly respects the United States" but "one must remember that ultimately, Israel is a sovereign nation and the Israeli government, defence forces and security services -- not others -- are responsible for Israel's security, future and existence".
On the sanctions track, the EU has postponed a final decision on an embargo. According to the Financial Times, British and French diplomats say Greece, which receives 25-30 percent of its oil from Iran, is the only state raising serious objections but that these should be overcome by the EU's self-imposed January deadline ("London and Paris to press EU for Iran oil embargo", Dec 6).
The newspaper quotes a diplomat as observing, "We have to help Greece find alternative sources of supply. But we think other sources can be found and the entire sanctions package is likely to be agreed."
Reuters cites a western diplomat as saying, "What's going to happen now is talks with the Saudis, Chinese, Koreans and Indians. Although the political will to impose the sanctions are there, they would only be effective if all the above players helped out -- not followed the sanctions but co-ordinated their response.".
EU members have achieved an internal consensus, according to EU Energy Commission Guenther Oettinger, but it is not clear precisely how sanctions are expected to work.
Some reports suggest an EU crude embargo would be imposed only if it would not affect overall oil supply and risk a spike. If the EU imposed an embargo, Iran would be able to continue to sell crude to China and other customers in Asia, albeit at a painful discount, cutting the Islamic republic's revenues.
Under this interpretation, Saudi Arabia would switch cargoes from Asia to make up the shortfall in Europe. Overall global supplies would remain unchanged.
Other reports suggest the aim is to cut Iranian export volumes. "Our assessment is that Iran will find it very hard to get other customers. The Chinese are already taking 22 percent of all their oil imports from Iran", and importing more would be "very dangerous" given the "potential instability", according to another anonymous diplomat cited by the Financial Times.
Attempting to cut Iran's exports would be far more risky. While Saudi Arabia could raise its own production to cover the losses, not just switch cargoes from Asia to Europe, that increase in output would cut spare capacity in the oil market and, other things being equal, push prices higher.
In a sign of how muddled policy has become, the Financial Times has one European diplomat warning, "The worry that we have is that the U.S. and Russia will try to compensate for the tough stance of the Europeans by offering Iran some carrots to come back to the negotiations."
The briefing war has resulted in a long list of partially contradictory views about how sanctions will work and their likely effects. It is one reason why official diplomatic briefings on an anonymous basis are so unsatisfactory for traders and analysts -- however convenient they may be for foreign ministries.
But in the meantime all the hawkish rhetoric about military action and sanctions has had no discernable impact on oil futures markets. Why?
One possible explanation is that enhanced geopolitical risk is offsetting a deteriorating economic outlook and keeping prices steady at a time when they would otherwise have fallen sharply on growing fears about an economic slowdown.
A second is that the market thinks any sanctions will be exquisitely tailored to leave European and global oil supplies unchanged.
A third is that the market simply does not believe all the warlike and sanctions rhetoric. Geopolitical risk has appeared to escalate many times before over the last five years, only to dissipate.
It is impossible to price geopolitical risk on Iran accurately. The number of real decision-makers is very small; access to information tightly controlled; and the significant decision-makers may not even have decided what they will do in various scenarios yet. (Senior policymakers generally prefer to keep options open until the last minute).
The market may simply be discounting incalculable risks about military action and sanctions, waiting to see how events turn out, to focus on the things it can price effectively.
In any event, the market remains blithely unaffected. Geopolitical factors currently have less impact on oil prices than the weekly U.S. inventory numbers. (editing by Jane Baird)