OIL prices have plummeted for the past two weeks, largely on dim projections for global growth. But an underappreciated, major threat to this trend lies on the horizon.

EU and US sanctions against Iranian oil exports are becoming too successful. In particular, an arcane insurance ban on tankers contained in European sanctions could force so much Iranian crude off the market that oil prices could spike.

Western policy makers should use their grip on Iranian oil revenue as leverage at the May 23 talks in Baghdad on Iran’s nuclear programme.

But regardless of the talks’ outcome, the European Union will have to suspend parts of its sanctions regime to avoid damage to the global economy.

Western sanctions that take effect this summer will significantly impede the export of Iranian crude. EU energy companies and insurance providers are currently allowed to fulfill existing agreements with Iran, but are proscribed from entering into new contracts or honouring any agreement as of July 1
Further complicating matters, a US law prohibiting any foreign bank from clearing payment for Iranian crude will take effect on June 28.

The main problem lies in the EU insurance provisions. Iran exports roughly 2.2 million barrels of oil per day. The EU bought 600,000 barrels per day in 2011, but will implement the embargo on July 1. The insurance measures could shut in much of Iran’s remaining export capacity. Ports will not accept tankers that do not have robust insurance.

Primary insurers will not issue sufficiently large policies without reinsurance, which distributes risk for potentially huge liabilities such as those involved in a major oil spill.

EU companies play a dominant and global role in the maritime reinsurance industry. Lack of access to European reinsurance would severely complicate shipment of Iranian crude to any customer. That includes China, Japan, India and South Korea – each of which purchased between 220,000 and 550,000 barrels per day from Tehran last year.

Iranian sales to these nations are already tapering more quickly than expected, as EU insurers deny coverage in advance of the coming ban. If much of these volumes, in addition to the EU embargo, were to become shut in, well over 1 million barrels per day of Iranian crude could disappear from the global supply.

Saudi Arabia is the main repository of spare capacity, and Riyadh claims it could add 2.5 million barrels per day to its current output, though many investors believe the number is lower.

Saudi spare capacity is the ‘’global cushion’’ for oil supply, and even the possibility that it could drop to 1.5 million barrels per day or below jolts markets and increases the barrel price, especially given doubts about Saudi capacity. If slashed Iranian exports lead to a drastically reduced Saudi reserve, currently falling oil prices would succumb to a more bullish market this summer.

There are ways out of this bind, but they are either unwise or unlikely to happen. A release from the US Strategic Petroleum Reserve could reduce the price of oil if markets tighten.

But because of Iran’s deep commitment to its nuclear programme, diplomacy is unlikely to end the crisis soon.

Tapping the reserve is not a longterm solution: If the United States uses a significant portion of it this year, and if Israel were to attack Iran’s nuclear facilities next year, America would be without a stockpile when it is most needed.

Alternatively, Asian countries could place their national credit behind tankers that carry Iranian crude. But nations are averse to committing public funds to cover potentially large liabilities, and tanker owners may be wary of a government’s willingness to pay claims in the event of a disaster.

How should Western policy makers deal with this dilemma? First, the EU and United States should use their leverage over Iran’s oil revenue at the Baghdad talks to obtain curbs on the most dangerous elements of Tehran’s nuclear programme.

Western officials should make it clear that Iran’s oil proceeds can be reduced to a devastating extent and that economic pain will be calibrated to Iranian policy. The gambit is tantamount to a high-stakes game of chicken, as Tehran will know that removing most of its oil from global markets carries a big risk for the West as well.

If the Baghdad talks fail to produce a deal, the EU will have to suspend, for perhaps six months, its ban on insurance of tankers that serve Iran.

Indeed, the Europeans reportedly have begun to consider this move.

Renewal of the suspension, partial implementation of the ban, or full reimplementation would become new arrows in the Western quiver of options.

Western sanctions on Iran are on the threshold of an overreach. That evolving reality might provide leverage at the talks in Baghdad. If it doesn’t, the West will have to dodge an approaching bullet, and turn its new leverage over Iranian oil revenue into a potent tool of diplomacy.