Iran: Misunderstandings and miscalculations

Escalating Middle East tensions point to Brent nearer to USD80pb rather than USD70 through 2H2018.

[Note: This article was first published in Arab Digest on 28 May. It has been lightly edited for technical reasons.]

“Iran will never again have carte blanche to dominate the Middle East.”

Secretary of State Michael Pompeo, 21 May 2018

When President Donald Trump walked away from the Joint Comprehensive Plan of Action (JCPOA) on 8 May, his overall ambition was reasonably clear. But the consensus — among not only the commentariat but also the other parties to the agreement — was that, at that stage, Washington had no ‘Plan B’ setting out how he proposed realising his goals. However, to an extent at least, this gap has since been filled by Mr Pompeo’s 21 May speech to the Heritage Foundation.

Coupled with the threat of “the strongest sanctions in history”, Mr Pompeo laid out 12 conditions by which Iran had to abide if it is to be granted a new deal on sanctions relief, including:

  • Abandoning totally and in perpetuity uranium enrichment;
  • Scrapping its ballistic missile programme;
  • Withdrawing all support for its allies in the region, notably Hamas and Hizbollah;
  • Withdrawing its forces from Syria and (to the extent they are present there) Yemen;
  • Stopping meddling in Iraq; and,
  • Ending all “threatening behaviour” towards other countries in the region.

Mr Pompeo made it clear that he expects full backing for his plan not only from America’s European allies but also from "Australia, Bahrain, Egypt, India, Japan, Jordan, Kuwait, Oman, Qatar, Saudi Arabia, South Korea [and] the UAE". But it is far from sure that this will be forthcoming. As has been well documented in the press, the three European signatories to the JCPOA — France, Germany and the United Kingdom — intend standing by their obligations under that agreement (difficult, if not near impossible, though it will be to protect their businesses from secondary US sanctions). India has already made it clear that it is very unlikely to toe the Washington line; not surprising given its growing economic ties with Iran. Kuwait, Oman and, perhaps especially, Qatar will not be enthusiastic. And even Japan — whose Prime Minister, Shinzo Abe, has been ill-rewarded on both the trade front and North Korea for his efforts courting Mr Trump — may balk.

As for the other JCPOA signatories, Russia has already openly condemned the US’s move; and President Vladimir Putin has shown some willingness to work with French President Emmanuel Macron to try to preserve the deal. China, on the other hand, has been conspicuous in its relative silence; but we may safely assume that Beijing will be looking for opportunities to deepen its economic engagement with, and geopolitical influence in, Iran, which is a key partner in President Xi Jinping’s ambitious Belt and Road Initiative (BRI).

In other words, despite Mr Pompeo’s seeming willingness to try to force compliance from third countries (including US allies) through secondary sanctions and the fact that business will undoubtedly follow Total and pull back in many cases, it seems very unlikely that the US will manage to conjure up the sort of united front internationally which was instrumental — indeed, essential — in brokering the JCPOA in 2015.

There may be some in Washington who genuinely believe, nevertheless, that the tough sanctions regime which Mr Pompeo has promised can be imposed on Iran; and that, as a result, Tehran will come to the table and capitulate. But it is unlikely that their number includes either Mr Pompeo or National Security Advisor John Bolton, both of whom are experienced and thoughtful operators. Indeed, we can be pretty confident that both realise that, far from weakening the regime’s resolve, the US’s current approach will strengthen the hardliners in Iran.

However, it is still likely that serious misunderstandings prevail in current thinking in Washington. Most notably, there does seem to be a belief there — quite possibly shared by Messrs Pompeo and Bolton — that the new US approach will somehow induce regime change in Tehran. But this certainly does not appear to be a view which is widely shared among Iran experts outside Washington. For example, David Gardner in the 22 May edition of the Financial Times (subscriber access only) put it as follows.

“What the Trumpian pyromaniacs have actually done is to re-legitimise hardliners in Iran grouped around the Revolutionary Guard Corps, the judiciary and the theocratic leadership. The 2015 accord re-energised the drive for change inside Iran. It gave Hassan Rouhani, architect of the accord, a second term as president. The guards and their supporters are now exulting after Mr Trump came to their rescue by scuppering it. The pragmatist camp led by Mr Rouhani has been politically crippled. How can they still argue Iran should continue to honour an international deal the US just ripped up?

The slim but real chance of a more open society in Iran under looser theocratic tutelage — there had been proposals for a leadership council to replace the Supreme Leader, 78-year-old Ali Khamenei, once he leaves the stage — has ended. Iranians dreaming of rejoining the world are instead faced with what Mr Pompeo said ‘may end up being the strongest sanctions in history’. Ranks are closing across Iran’s diverse spectrum. Bolton-esque regime change is a fantasy.”

Mr Gardner goes on to note that, even though expert opinion is skewed towards the US failing in its objectives, a direct military strike on Iran per se by either the US or Israel (let alone Saudi Arabia) remains unlikely. But this does not rule out, by any means, a further escalation of the ongoing proxy wars in the region. Indeed, it may be just a taste of things to come and no coincidence that Iran’s first ever attack on Israeli-held territory came just hours after Mr Trump had effectively withdrawn the US from the JCPOA.

Thus, the biggest immediate related risk probably lies not with Iran and the US but in Iran/Israel relations. The missile attack last month by Iranian (or, possibly, Iran-backed) forces based in Syria on the Israeli-occupied Golan Heights already amounts to a significant escalation. Israel’s retaliatory airstrikes (which appear to be ongoing albeit with no visible impact on the oil price — see below) may serve to slow down the Iranian build-up in Syria. But Tehran is not only very unlikely to back off but will also very likely look to retaliate against Israel in some way, possibly by terrorist attacks on Israeli (or possibly US) assets or citizens in third countries. Such a step would not go unpunished and, although it seems unlikely that either party wants an all-out war, we appear to be sliding dangerously towards the point where this could occur through miscalculation, if not deliberation.

Oil: On the one hand…

"Looks like OPEC is at it again. Oil prices are artificially Very High! No good and will not be accepted!”

Donald Trump (on Twitter), 19 April 2018

Clashes between Iran and Israel in the Golan area do not, of course, pose any direct threat to oil output (which may not, of course, prevent further knee-jerk price rises if and when there are more confrontations). But the oil market does currently have to cope with at least two other essentially political risks. First, we saw Venezuela’s output fall almost 20% last year, attributed largely (and correctly, in my view) to a combination of incompetent management and the country’s dire domestic political situation; given the ever-increasing political precariousness there plus the very real possibility of US sanctions, who is to say that there isn’t more to follow? Second, at the start of April the Houthi rebels in Yemen twice launched missile attacks on Saudi Arabian oil-related assets in that period. As David Sheppard highlighted in the 5 April edition of the FT (subscriber access only):

"Oil traders, distracted for now by a brewing trade war between the US and China, are at risk of growing complacent. But it is unlikely they will be able to discount Saudi Arabia’s conflict in Yemen much longer.”

Coupled with Mr Trump’s withdrawal from the JCPOA, Brent hovering around USD80p as it was in mid-May (ie up around USD14pb since the start of the year and USD5pb in the wake of the 8 May announcement) hardly seems unreasonable.

However, it is not clear as yet that US actions will cut Iran’s exports, currently around 2.6mbpd; or, if so, by how much. Some experts have speculated that we may lose around 200,000bpd from international markets; on the other hand, Tehran is putting the EU under considerable pressure to protect its oil exports if the Europeans wish to preserve the JCPOA.

Furthermore — and almost certainly accounting largely for Brent’s slide back below USD76.00 at the start of this week — it is possible that Saudi Arabia and Russia may agree to boost output (as Mr Trump has demanded) by as much as 1mbpd, nominally to offset any lost exports from Iran (but, to a large extent, compensating for over-compliance with Opec-agreed cuts). Opec would, in my view, endorse any such agreement when it next meets on 22-23 June, although sorting out new quotas could prove tricky given the small number of members with the capacity to increase output.

An additional downside risk to the current price lies in Mr Trump’s trade agenda. During the week of the two Houthis missile attacks on Saudi oil-related assets, Brent actually sold off by around 3% over concerns that China and the US were about to slide into a trade war. This risk clearly still exists even though it is currently hard to determine whether it is rising or falling.

In short, investors are faced with upside and downside risks to the current oil price and the likelihood that the relative strength of those risks will continue to fluctuate, driving more volatility into the oil market. Many experts consider Brent at USD70pb to be a ‘sweet spot’, ie high enough to sustain output but not so high that it crimps demand. Nevertheless, given the high probability of tensions in the Middle East continuing to rise and repeated reports of Riyadh’s desire to sustain a price of USD80pb (not least with an eye to the proposed listing of Saudi Aramco), my personal view is that we are still more likely to see Brent around the 80 mark than USD70 through the second half of the year.

Alastair Newton

[Note: The image at the top of this article is the cover of the box set of Homeland Season 6. The story line includes a subplot where the prime minister of Israel persuades the US president to launch a war against Iran.]