January 3, 2020 / 1:15 PM / 23 days ago

Oil jumps as traders weigh uncontrolled escalation risk in Middle East: Kemp

LONDON (Reuters) - The U.S. air strike that killed a top commander of Iran’s revolutionary guard in Baghdad seems to have been intended to restore strategic deterrence in the aftermath of the assault on the U.S. embassy in the Iraqi capital.

FILE PHOTO: A general view shows Mexican state oil firm Pemex's Cadereyta refinery, in Cadereyta, Mexico October 5, 2019. REUTERS/Daniel Becerril

The aggressive response implies the United States still believes it has “escalation dominance” and Iran will absorb the blow rather than trying to match it or risk escalating the conflict further.

Officially, the United States remains committed to a policy of coercive diplomacy, steadily increasing economic pressure through sanctions to persuade Iran to resume negotiations on nuclear and regional security issues.

But Iran has refused to negotiate under sanctions and tensions between the two countries have been steadily increasing (“Iran promises to avenge U.S. killing of top commander Soleimani”, Reuters, Jan. 3)

The lack of movement on the diplomatic front has caused the focus to switch to military operations as both sides try to increase their leverage and force a resumption of negotiations on their own terms.

Qassem Soleimani’s killing is the latest incident in the “shadow war” between Iran and its regional proxies on the one hand, and the United States and its allies, including Israel, Saudi Arabia and Britain, on the other.

The undeclared conflict has included attacks on tankers, industrial sabotage, cyber warfare, assassinations and hostage taking, as well as on U.S. bases in Iraq and oil installations in Saudi Arabia.

OIL MARKET IMPACT

So far, sanctions on Iran’s exports and low-level military confrontation have not had a lasting impact on the oil market (“Attack on Saudi Abqaiq finds the oil market’s Achilles heel”, Reuters, Sept. 16, 2019).

In 2018, big reductions in the volume of Iran’s exports as a result of U.S. sanctions were offset by increased output from Saudi Arabia and U.S. shale producers, ensuring oil supplies remained plentiful and prices fell.

In 2019, attacks on tanker shipping in the Strait of Hormuz and on oil installations in Saudi Arabia had only a transient effect on prices because of plentiful shale production and slack global oil consumption growth.

The increase in oil prices following Soleimani’s killing, with front-month Brent futures up by around $2.50 per barrel (4%), suggests oil traders think the pattern will be repeated.

The small rise in Brent indicates traders are so far pricing in a low but non-zero probability of significant uncontrolled escalation across the region disrupting oil supplies.

ESCALATION CONTROL

Both countries insist they are prepared for a full-scale armed conflict, while saying they do not seek it or think it likely.

Both have pursued a mixed strategy of escalation (increased sanctions, attacks on oil infrastructure) and containment.

And both have signaled at various times that they want to avoid provoking a full-scale and uncontrolled confrontation.

The United States has pursued a policy of strategic patience to give sanctions time to work, rather than resort to heavy armed force, in the belief a weakening economy will eventually force Iran to negotiate on more favorable terms.

The U.S. government believes time is on its side so there is no rush to bring the economic and military conflict to a crisis, which could also weaken support for its sanctions policy among its European and Middle East allies.

In turn, Iran has pursued its own version of forward defense, trying to push the conflict away from its own territory into neighboring states, and raise the cost of sanctions on the United States and its allies.

MISCALCULATION RISK

Soleimani’s killing represents a serious escalation of the conflict because he was identified as the architect of Iran’s forward defense policy.

It remains unclear why the United States selected such a high-value target at this particular point, especially since it will likely provoke reprisals and impose some costs on U.S. intelligence collection efforts.

Iran will likely review its operational security and conduct a counter-intelligence sweep to identify the source of information that enabled the United States to locate its commander in real time.

The killing is likely to impose real costs but presumably the White House and senior decision-makers decided they were worth it to send a strong deterrence signal to Iran and reassure regional allies about U.S. resolve.

It remains unclear whether Soleimani’s killing will mark a shift in the strategic calculations of either party (“Strait of Hormuz and the risk of uncontrolled escalation”, Reuters, June 13, 2019).

But the biggest risk has always been that a miscalculation by one or both sides, or their allies, could lead to spiraling conflict, possibly spreading to multiple sub-theaters across the Middle East.

Coercive diplomacy requires exquisite calibration of the degree of pressure to ensure controlled escalation does not spiral into uncontrolled escalation.

Previous escalations, including attacks on shipping in the Strait of Hormuz, oil installations in Saudi Arabia and the downing of a U.S. military drone, have all been followed by a successful effort to reduce tensions.

Contained conflict probably reflects the strategic preferences for both countries, but the more incidents, and the more serious they become, the greater the risk that one will provoke an uncontrolled escalation.

(John Kemp is a Reuters market analyst. The views expressed are his own)

Editing by David Evans

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