No one is interested in escalating the conflict

No one is interested in escalating the conflict

At the end of last year, we believed that the geopolitical tensions would ease, and we would enter 2020 with prospects of continued growth in the global economy. We also expected ample supply on the oil market and a downward trend in oil prices. On the night of January 2nd, an American missile attack in Baghdad killed General Qasem Soleimani, head of the Iranian Al-Quds force, and Iraqi militia commander Abu Mahdi al-Muhandis. After Iran’s announcement that it would retaliate and the United States’ sharp response, the tension between the two countries is undoubtedly nearing its zenith.

So what lies ahead? In what direction will oil prices move? From today's perspective, this is difficult to predict given the uncertainty about what each side of the conflict will do next. The situation is complicated by the involvement of Iraq, the second largest oil producer in OPEC. The Iraqi Parliament passed a resolution calling on the US forces to leave its territory immediately. It is pretty certain that the geopolitical factors will weigh on oil markets for some time since the conflict is unfolding.

When the geopolitical tensions in the Gulf region are reaching an unprecedented level, the scenarios that come to the fore are those anticipating the risk of oil supply disruptions and production declines. They predict an upward movement in the oil price, depending on the assumed size of supply reductions. Such scenarios are most often envisaged by the apprehensive financial markets. However, this time the geopolitical shock occurred in an oil market where the supplies are abundant. This is undoubtedly due to the resilient shale oil production in the US, new supply sources in Brazil and Norway, as well as OPEC’s lesser consistency in complying with its production cuts agreement. These factors combined should have led to a situation where, after the 0.5 mbd fall in 2019, oil supply would grow again in 2020 (by some 2.0 mbd). With the expected moderate increase in demand in 2020 (of 1.2 mbd, as estimated at the end of December), the oil price was expected to fall (from USD 64 per barrel in 2019 to USD 58 per barrel in 2020). The oil market has no shortage of reserves that can be quickly brought on stream. There are significant oil inventories, and both free production capacities and strategic stocks are available, so the upswing in prices directly after the attack was relatively small. Since January 2nd 2020, the oil price has moved up by about USD 4-5 per barrel, and every surge was followed by a decline. At the time of preparing this post, at noon on January 8th, Brent oil cost less than USD 69 per barrel. Considering how the price behaved so far, no major tension is being seen on the oil market.

On January 6th, the Continuum Economics (CE) think tank put forward a bold scenario developed by CE's managing director and head of strategy, Mike Gallagher. I have found it very interesting that in this tense situation accompanied by significant uncertainty, the author makes a bold thesis and justifies it convincingly. “While there are concerns that events in the Middle East will spiral out of control, it is more likely that Iran’s response to the assassination of top general Qassem Soleimani will be measured and designed to avoid major escalation. After a temporary period, geopolitical tensions will likely de-escalate and oil prices drift lower. We maintain the view that WTI will end 2020 at $55, as new supply from Brazil and Norway adds to the further expansion of shale oil production in the U.S.”

The author does point to the high level of uncertainty as to Iran’s possible further actions and, as a formality, outlines the worst case scenario (with Iran’s strong attack on American (military or civilian) assets in the Middle East, triggering a disproportionate response on the part of President Trump) but does not elaborate on it. He believes a measured response from Iran is more likely, due to three factors.

The unpredictable Donald Trump. After a modest response to the Iran-backed attack on Saudi Arabia oil facilities in September 2019, now there was an aggressive move against the chief commander of Iranian defence forces. Perhaps US patience has been exhausted, or what we see is typical ‘engineering’ on the part of Trump, designed to distract attention before the impeachment process starts in the Senate (in a similar situation Clinton attacked Iraq in 1998). In any case, it is difficult for the Iranian leaders, who seem to prefer a balanced response over heavy retaliation, to guess what decision the American president will make. Trump does not want war but readily counters Iran for tactical reasons. A key issue here is the better military position of the US, as an aggressive reaction of Iran could lead to an attack on military targets in this country.

Iran’s long-term game and economy. The Iranian leadership used to play for the long term in an attempt to maintain the regime. The wars started by the US in Afghanistan and Iraq after the attacks of September 11th 2001 led Iran to de-escalate and suspend its nuclear programme. Moreover, the country’s economy is suffering because of the re-imposed US sanctions, and based on IMF estimates it contracted by 9.5% in 2019, partly due to widespread protests in November. Iran does not want war with the US.

Russia‘s and Turkey’s reluctance to engage. While Russia and Turkey willingly cooperate with Iran from time to time, each of them is more interested in expanding their influence in the Middle East than in getting involved in the US/Iranian conflict. Russia and Turkey are likely to exploit every weakness of Iran in Syria and potentially in Iraq.

Gallagher believes that Iran’s balanced response will most likely consist of four elements.

  • First, an attack supported by allies. This could include some incident in Syria, Yemen, Iraq or against Saudi facilities, but probably on a lesser scale than the attack on Saudi oil facilities in September 2019.
  • Second, an attack on tanker ships in the Strait of Hormuz. Iran may also harass or attack ships coming from Saudi Arabia to temporarily increase oil prices and to put pressure on Western politicians by creating a threat of higher fuel costs. However, blocking the Strait will not be a likely intention and such actions are likely to be the same as in 2019.
  • Third, a threat of accelerating the uranium enrichment programme. During the weekend Iran already indicated that it would suspend all uranium enrichment restrictions and remove all limitations on the number of centrifuges it has in operation, raising concerns about possible development of its nuclear weapon capabilities in the future. However, Iran has not fully terminated the 2015 deal and will cooperate with the UN International Atomic Energy Agency. This suggests that its current actions may be a of temporary nature.
  • Finally, cyberattacks. Iran has the potential to undermine the US commercial interests through cyberattacks, but this needs to be balanced as the US has greater capabilities in this respect.

The authors of the scenario argue that if the Iranian reprisals are moderate, they will probably produce only a small response from the US. The motives of the US President are mixed and potentially temporary. In addition, the US would like to keep its troops in Iraq to avoid a new civil war and prevent Iran or ISIS from using the vacuum created by their leaving to their advantage.

In the morning of January 8th, Iran attacked 17 US military bases in Iraq with missiles, 15 of which reached the target. The operation was called ‘Martyr Soleimani’ and, according to Iranian sources, killed 80 people. The Islamic Revolutionary Guard Corps threatened to attack Dubai and Haifa if Americans responded. Israel is concerned about the situation: Prime Minister Benjamin Netanyahu warned that its country would respond with military action to anyone who attacked it. What is important is that according to the American side, only two missiles reached their target but did not cause any losses. Mike Gallagher's scenario seems to be materialising.