Weakened Iran Shows It Can Still Hold the Global Economy Hostage

(Bloomberg) – Sun Tzu, the author of the 2,500-year-old The Art of War, is overquoted, but even in ancient China he knew the value of asymmetrical warfare—how smaller forces, such as guerrillas or today’s drones, possess advantages over huge ones, like standing armies or zillion-dollar fighter jets. He also knew to provide a battered opponent an escape, advising the conquering side to “leave an outlet free. Do not press a desperate foe too hard.”

Both of those lessons are on display in Iran. President Trump’s “maximum pressure” strategy has weakened Iran and hobbled its economy as intended. But it’s also made that country more dangerous, pushing it to strike back in unconventional and hard-to-counter ways, with its leaders rejecting a return to talks while their backs are up against the wall.

Since Trump withdrew from the 2015 agreement meant to contain Iran’s military ambitions and curb its nuclear program, the Islamic republic and its proxies have been hinting at their capacity to play spoiler. They’ve seized tankers, interfered with oil-shipping lanes, and hit archnemesis Saudi Arabia with repeated drone and missile strikes. But the attack on the world’s biggest refinery on Sept. 14—blamed by many on Iran, which denied it—prompted a panic and record increase in oil prices. While prices fell in the following days, the attack still disrupted markets from Tokyo to New York because of the prospect of a disruption to global energy supplies.

The upshot is that a weakened Iran is in a better negotiating position than ever, holding the world economy hostage as it faces down an effort led by Trump, Saudi Arabia, and Israel to force it into submission. Conflict-averse nations in Europe and Asia are responding by trying to pull Iran back from the brink with diplomacy and credit lines. And countries that stand to be roped into a war, such as the United Arab Emirates, are getting cold feet about their investment in the campaign against Iran.

“This is how Iran practices deterrence,” says Thomas Juneau at the University of Ottawa’s Graduate School of Public and International Affairs. “A key pillar of Iran’s defense doctrine is to continually send signals and reminders to the U.S. and its regional allies and partners that it has the means to hurt them. The global economy is vulnerable. By sending this powerful signal, Iran is reminding everyone that a war would be very costly.”

The attack on the world’s largest oil-processing plant, which halved Saudi production, knocked out about 5% of global supply and sparked doubt about what’s been billed as potentially the largest stock listing in history: that of Saudi Arabian Oil Co., the state oil company known as Saudi Aramco. It was also proof of how profitable Iran’s investment in asymmetrical warfare has been. While Saudi Arabia put money into conventional weaponry, becoming the third-largest spender on military equipment worldwide after the U.S. and China, Iran invested in forces of disruption—in Yemen, Iraq, Syria, and elsewhere.

Tehran’s strategy seems to be paying off. As the U.S. disengaged from Iraq, Iran became that country’s dominant external influence. It has armed proxies in Syria and Lebanon and through them plays a decisive role in those countries’ politics, threatening neighbors like Saudi Arabia, the U.A.E., and Israel.

Yemen has raised the risk of a broader Middle East conflagration in the Arabian Peninsula and the Gulf. The impoverished nation with a population of 30 million and an economy smaller than that of Boise, Idaho, has been reduced to rubble in an all-out battle for supremacy between Iran and Saudi Arabia. Yemen’s troubles deepened in 2015, when an Iranian-backed tribal group called the Houthis seized the presidential compound in the capital Sanaa, prompting the resignation of the government. The proxy war between Riyadh and Tehran then took a step closer toward direct warfare when Saudi Arabia and the U.A.E. intervened, setting off a conflict and humanitarian catastrophe that’s left more than half of Yemen’s people on the brink of starvation, according to the United Nations. In strategic terms, Iran, through the Houthis, had gained a foothold in Saudi Arabia’s backyard.

From the start of the fighting, the Houthis warned they’d respond to Saudi involvement with attacks on the kingdom—and indeed they claimed responsibility for the Sept. 14 strike on the oil facilities. There are other theories: The attack may have originated in southern Iraq (which has elements friendly to Iran) or even parts of Iran. U.S. Secretary of State Mike Pompeo has rejected the Houthi claim and holds Iran directly responsible. But the debate is almost beside the point. The Houthis get their increasingly sophisticated weapons from Iran.

“The Iranian strategy of using proxies to give itself a degree of plausible deniability and to avoid direct retaliatory attacks on itself is well-established,” says Emily Hawthorne, a Middle East analyst at Austin-based risk consultant Stratfor Enterprises LLC. “It could be that sanctions-burdened Iran sees pushing to the edge of war as the only route to a de-escalation.”

It’s hard to say how bad the economic impact of such attacks could be without knowing how long it will take to fix the damage. Aramco has promised to insulate customers by supplying them with oil held in reserve and said it would return to pre-attack production—4.9 million barrels a day—by the end of September. But even when output is fully restored, there will likely be a new risk premium built into the price of oil because of how vulnerable Saudi Arabia’s supply has become. It’s easy to imagine another attack as bad or worse.

The spike in oil prices hits a global economy already showing signs of weakness. China just reported the worst single-month reading for industrial output since 2002. In July the International Monetary Fund cut its global growth outlook—already the lowest since the financial crisis—to 3.2% this year and 3.5% next; a rate of 3.3% or lower would be the weakest since 2009. “A negative supply shock like this, when global growth is in a synchronized slowdown with many geopolitical hot spots simmering, is just what we don’t need,” says Rob Subbaraman, head of global macro research at Nomura Holdings Inc. in Singapore.

For countries that produce far more oil than they consume—Iran, for example—the price spike is an economic positive. For the U.S., the impact will be mixed. While consumers will pay more at the pump, oil-producing states such as Texas will benefit from increased investment, and nimble shale producers are likely to expand production. The attack damaged facilities that process light and extra-light crudes. The U.S. is a key non-OPEC provider of those. “This means that the U.S. shale industry will directly benefit,” Vienna-based consultants JBC Energy GmbH wrote in a note on Sept. 16. “We would expect a surge in U.S. crude exports over coming months.”

But it’s the worst kind of price spike for the global economy. One caused by strong demand can be dealt with by raising interest rates to cool off demand. But a spike caused by a supply disruption, like this one, is harder to treat. The higher prices take money out of the pockets of people who are already hurting, so raising interest rates just makes matters worse.

Such a scenario would amount to Iran spreading around some of the pain it’s feeling at home. Since Trump inaugurated his maximum pressure campaign, the Iranian currency has tanked. Government efforts to forcibly fix the exchange rate and shut down consumer foreign exchange trading backfired when the power of the black market prevailed. At the worst of its slump in September 2018, the rial had lost 70% of its value since the beginning of that year.

Imports skyrocketed, and the government enforced a wide-ranging ban on nonessentials to protect foreign exchange supplies. Once-abundant foreign goods can no longer be found. In some of Tehran’s poshest and busiest shopping districts, such as Nelson Mandela Boulevard and Khoddami Street, rows of shops that once displayed Turkish and European clothing brands are empty or have been turned into restaurants. Critical medication, supposedly excluded from sanctions, has become scarce because foreign companies don’t want to risk doing business with the pariah Islamic republic.

The Europeans have been trying to defuse the situation—and the recent attack appears to be providing extra impetus. French President Emmanuel Macron has been leading the endeavor to bring everyone back to the negotiating table and avert a larger crisis. He’ll keep up those efforts in the wake of the latest attack, according to two officials in his office who asked not to be named speaking about behind-the-scenes deliberations. Giving up would provide a victory to hawks not only in Iran, but also in the U.S., one adviser says. Germany is supporting Macron’s efforts, according to a German government official, who also asked not to be named. The person says Germany is so far pleased that the parties, Saudi Arabia included, appear to be avoiding an escalation. Many officials are pointedly refusing to mention Iran in their condemnations of the attack. Johannes Wadephul, deputy caucus leader for German Chancellor Angela Merkel’s Christian Democratic Union in the Bundestag, criticized Trump instead. “Maximum pressure is not a policy,” he said. “The situation is becoming more dangerous every day.”

Trump has alternated between belligerence (the U.S. is “locked and loaded” to respond, he tweeted the day after the attack) and backtracking. A later tweet minimized the impact on the U.S., pointing out that America is a net energy exporter. “We don’t need Middle Eastern Oil & Gas, & in fact have very few tankers there, but will help our Allies!” he posted.

Iran is probably taking comfort in—if not actively counting on—Trump’s often expressed unwillingness to embroil America in another foreign war. (On Sept. 18 he said, “How did going into Iraq work out?”) The Shiite nation may also be encouraged by its Sunni rival Saudi Arabia’s lack of appetite, or aptitude, for a fight. Despite spending 8.8% of its gross domestic product on its armed forces, the kingdom has been unable to defeat the Houthis in Yemen, where it outsourced much of the fighting to Sudanese troops. It has also proved incapable of defending its territory against repeated attacks. Saudi Arabia is unlikely to act against a more formidable foe like Iran without the protection and encouragement of the U.S.

“The U.S. refuses to admit that Iran has leverage and that we often play on their terms,” says Aaron Stein, director of the Middle East program at the Foreign Policy Research Institute in Philadelphia. “They have rightly concluded we won’t intervene and topple the regime, so they play with house money. They are feeling economic pain, but the regime is safe, giving them a distinct advantage in an indirect showdown.”

This makes for the ultimate test of the dealmaking skills Trump likes to boast about. After withdrawing from Barack Obama’s nuclear deal seemingly without a plan beyond punishing Iran, the U.S. president is in an awkward position trying to restart any kind of negotiations. He’s replacing ultra-hawkish John Bolton—fired as national security adviser—with special envoy for hostage affairs Robert O’Brien. But, if Trump and Tehran do sit down again, can he at least “leave an outlet free” for the Iranians to avert further escalation?

“Trump is already equivocating 48 hours after a devastating attack on Saudi Aramco,” says Barbara Leaf, senior fellow at the Washington Institute for Near East Policy and former U.S. ambassador to the U.A.E. “The issue of whether or not the U.S. will lead a robust response to this attack—diplomatically, not militarily—is what will hang over this administration for the rest of his term in office.”