Escalation In Iran Bodes Ill For The Economy

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resident Trumps decision to bomb Iranian nuclear facilities represents a major escalation in the conflict over Iran’s nuclear ambitions and could presage turmoil in the world economy but especially the oil market. Iran and its proxies have been seriously weakened by Israel in recent months, but that is not the same as being toothless.

Despite the desire of Israel’s Prime Minister Netanyahu, the fighting is unlikely to lead to regime change. Historically, citizens have rallied to their leaders no matter how unpopular against foreign aggression, the most recent case being Saddam Hussein’s invasion of Iran in 1980, which he thought would encourage the Iranian people to rise up, especially those Arabs in the southwestern part of the country. The opposite actually happened.

While the Iranian regime is outraged and at least initially appears less likely to negotiate, there is a possibility that they will seek a new agreement that would end the attacks and remove the sanctions. Unfortunately, it is not clear that Israel (or at least the current government) will accept any agreement and that would mean a continuation and even spreading of the conflict.

The uncertainty now is whether and how Iran might respond militarily. Missile attacks on Israel will continue as long as Israel is bombing Iran and the seems to be no exit ramp for Israel: Netanyahu doesn’t trust the Iranian regime and regards it as an existential threat to his country, and only the strictest agreement would appease Israel. Iran appears unwilling to make such concessions.

The two most serious military scenarios are: proxy attacks against U.S. forces, especially by Iranian-backed militias in Iraq, or attacks on oil shipping in the Persian Gulf and/or Straits of Hormuz. The nightmare scenario of an Iranian attack on Saudi oil facilities, long a worry of energy security experts, can probably be ruled out: the 2019 attack was largely a failure and relations between Saudi Arabia and Iran have improved. Perversely, Iranian attacks on U.S. forces in the region could see an American attack on Iranian oil facilities. That would contradict President Trump’s stated desire for lower oil prices, but cannot be ruled out.

Swarming drones, missiles and speedboats could undoubtedly wreak havoc on Gulf shipping, sending oil prices soaring over $100 if even moderately successful as shipping companies avoid the Gulf until the situation stabilizes. The U.S. Navy would retaliate and do significant damage to Iranian naval forces but will hardly be able to completely secure shipping in the region. Bombing missile launchers can reduce those attacks, but drone swarms would remain a threat and many shippers would be unwilling to enter the Gulf should such continue. Ultimately, if the attacks dwindle, some shippers will take the risk, given higher shipping rates, but there would certainly be a disruption in supplies and higher prices for weeks, perhaps months.

The paths for Iranian leaders are threefold: attempt to continue negotiations, seek to de-escalate the fighting with major concessions, possibly after a few demonstration attacks, or assume that negotiations with Trump and/or Netanyahu are fruitless and go all in on military retaliation. In the earlier round of Iran-Israeli missile and drone exchanges, the Iranians seemed to prefer de-escalation but they might now feel such is fruitless.

In that last case, threats to shipping and oil supplies more generally will continue for a prolonged period and while, in the long run (meaning months), the supply taken off the market might be minimal, the uncertainty will keep the security premium on oil elevated. Prices might not reach $100 a barrel without large-scale attacks on shipping, but the combination of uncertainty about the threat to tankers and fears of new escalation would keep prices in the $90 range for an extended period. As mentioned in the previous column, this would reduce GDP by up to 0.5% and raise inflation by as similar amount. Whether that persists will determine whether the Fed has to raise rates to offset that

The nightmare scenarios of an attack on regional oil facilities or massive interdiction of shipping in the Gulf will depend on whether the Iranian regime feels so threatened it decides that massive escalation is their only option. Given surplus capacity in some OPEC countries and strategic stocks around the world, a 1970s-style oil crisis and recession should be avoided, but turmoil and uncertainty never produce positive economic results. Expect a difficult summer.