The European Union is becoming skeptical about slapping sanctions on imports of Iranian oil, diplomats and traders say, as awareness grows that the embargo could damage its own economy without doing much to undercut to Iran's oil revenues.

Oil accounts for 50 percent of Iranian budget revenues, and those arguing for sanctions say they can deprive Tehran of billions of dollars and derail what the West sees as Iran's attempts to build a nuclear bomb.

But diplomats and oil industry insiders say Europe may calculate that even a small rise in oil prices as a result of an introduction of an EU-wide embargo would more than compensate Tehran for any losses from being obliged to re-route displaced supplies to Asia at discounted prices.

Maybe the aim of sanctions is to help Italy, Spain and Greece to collapse and make the EU a smaller club, one trader joked.

The remark reflects the growing unease that EU sanctions would hit hardest some of the continent's weakest economies, because Iranian oil provides the highest share of their needs, not to mention the rest of the bloc.

The likely increase in oil prices that would result from a ban would be felt by all (European) oil refiners, not just those that are big customers for Iranian oil, ratings agency Fitch said last week.

An oil industry source in Greece, which mostly relies on Iranian oil, said: Greece can't be put with its back to the wall.

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Graphic on Iran oil exports: http://link.reuters.com/jad45s

Sanctions imposed on Iran: http://link.reuters.com/had45s

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The threat to Iran's oil exports and fears about a possible military strike on its nuclear facilities [ID:nN1E7B305X] have helped keep oil prices above $100 a barrel despite sluggish global growth and a gradual return of Libyan oil supplies.

Iran, the world's fifth-largest oil exporter, has said it cannot rule out a self-imposed oil embargo to punish the West and on Sunday warned that oil prices could spike to $250 a barrel as a result of sanctions.

The United States has long banned Iranian oil imports and is now moving to ban dealings with the central bank of the Islamic Republic.

Supporters of sanctions say an EU ban would not amount to a supply disruption. Iranian oil displaced from Europe would flow to China, displacing existing sources of Chinese oil towards Europe. They say Beijing, as Iran's buyer of last resort, would then have the leverage to drive a hard bargain on prices.

However, calculations by U.S. research firms and traders show the discount could be as small as a couple of percentage points.

Sanctions critics say the regime of Iraqi former dictator Saddam Hussein was able to withstand sanctions for years.

SAUDI CONTINGENCY

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, said a Western diplomat.

Saudi Arabia, the only oil nation with spare capacity, faces a tough choice. Shipping more oil to Europe to replace lost Iranian barrels could mean ceding promising Asian markets to Iran, its political foe.

The Saudis have already started assessing the volume of Iranian supplies that go to their own big buyers.

It is sort of a contingency plan to know to what extent they can fill the gap and minimize the impact on the market, the source familiar with the Saudi strategy said. The Saudis want to know their options if something happens.

A source close to the Saudi oil industry in Europe also said Riyadh would consider raising supplies if Iranian oil was lost.

Saudi Arabia has already helped to substitute Iranian supplies once this year, when Tehran threatened to halt oil to India due to a payment dispute which followed U.S. pressure on New Delhi to reduce dealings with Iran.

This week, refiners in India, South Korea and Japan indicated they are reluctant to buy more Iranian crude, fearing that payments troubles could resurface again.

To make sanctions effective, the Europeans would have to go to the Chinese to ask them not to take more oil, said a senior oil executive, who added that he did not expect sanctions to take place at least until the second quarter of 2012, when seasonal demand eases.

EU politicians have said a decision is unlikely before January at the earliest.

However, industry sources say China has repeatedly shown it is ready to absorb any incremental cheap supplies, especially given that Iran has offered no concession to China or any other buyers in negotiations underway for prices for 2012.

Plants will be very happy to take more, said one source at China's Sinopec, Asia's largest refiner. It's definitely good news to Chinese plants if that's the case.

(Additional reporting by Florence Tan in Singapore, Meeyoung Cho in Seoul, Osamu Tsukimori in Tokyo, Aizhu Chen in Beijing, Jessica Donati, Christopher Johnson, Zaida Espana, Ikuko Kurahone. Editing Richard Mably and Jane Baird)

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