Detente With Iran: An Update by Bill O’Grady of Confluence Investment Management LLC

This report is an update to a similarly titled piece published in 2013 (see WGR, 10/7/2013, Détente with Iran?). The primary impetus for this update comes from a recent article by Michael Doran outlining President Obama’s “secret” Iran strategy,1 but similar themes have also been offered by other strategists.2

In this report, we will delve further into what appears to be an evolving policy change by the U.S. with Iran, and discuss the basic goals of the U.S. and Iran. With this background, we will examine America’s alternatives to achieving our aims in the region. A full examination of U.S. difficulties in making a historic change in policy with Iran will follow. From there, we will discuss the recent pattern of policy in the region and how it supports the notion that improving relations with Iran is probably the reason for this pattern. As always, we will conclude with market ramifications.

U.S. Goals in the Middle East

The primary goal of the U.S. in the Middle East is to ensure that oil flows from the region are unimpeded. This means that no single power in the region controls the flow or any outside power (save the U.S., of course) affects those flows either. The secondary goal is to execute the primary goal with an economy of effort. After the Cold War ended, the region’s importance slipped somewhat. There was no real outside power that could affect the region and the U.S. wanted to focus elsewhere, namely, the Far East. However, that shift has proven difficult because of persistent instability in the Middle East.

Why has the region become unstable? Since WWII, the U.S. has managed the Middle East through a balance of power arrangement, pitting the two largest powers, Iran and Iraq, against each other. Saudi Arabia, with the strongest economy, generally supported Iraq against the Shiite threat from Iran. The best example of how this policy developed was during the Iran-Iraq War. The conflict, which spanned eight years, kept both Sunni and Shiite powers occupied. Neither was able to defeat the other and the war ended with a stalemate.

In general, the Saudis combined with the Hussein regime, and the Emirate States could prevent either Turkey or Iran from extending power in the region. However, this coalition could not have fended off the combined power of Turkey and Iran. Fortunately, those two nations have generally shown little interest in cooperating.

The balance of power strategy fell apart after Saddam Hussein, angry at his inability to sway OPEC (read: Saudi Arabia and the Emirate states) into cutting oil production to lift prices and improve Iraq’s economy, invaded Kuwait on Aug. 2, 1990.

Within a day, resistance against Iraq had ended and the country was annexed by the Hussein government. In response, after being invited by Saudi Arabian King Fahd, U.S. troops moved into eastern Saudi Arabia to prevent Iraqi troops from moving south. In the coming weeks, the Bush administration pieced together a large international coalition against Iraq. Coalition airstrikes began on Jan. 17, 1991. The ground campaign began on Feb. 24, 1991, and ended four days later.

Although the ouster of Iraqi troops from Kuwait was a stunning success, the aftermath was less clear cut. The Bush administration did not have a mandate to remove Hussein and it wasn’t clear that this action would have been prudent. After all, a leaderless Iraq would have hardly been a counterbalance to Iran. Unfortunately, the best the Bush and Clinton administrations could come up with was persistent sanctions, no-fly zones and hope for a coup. The longer sanctions were in place, the weaker Iraq became. Although Iran never threatened Iraq directly, there was a risk that, at some point, Iran would seek revenge for the 1980-88 Iran-Iraq War.

As time passed, the U.S. faced this dilemma. Since Saddam wasn’t going away quietly, he would either have to be rehabilitated to restore the balance of power or a new government would need to be installed. In 2003, the George W. Bush administration opted for the latter course with disastrous results. However, for those who criticized the decision, the status quo could not have been maintained indefinitely; at some point, Iran would have attacked Iraq, prompting a broader conflict.

U.S. troops exited Iraq in 2011 after the Obama administration could not work out a plan to leave a residual force in place.

According to reports, Iran insisted that U.S. troops leave Iraq; it appears the Obama administration didn’t press against this demand.3 And so, at present, the U.S. is reluctantly playing the role of balancing power in the region.

Iran’s Goals in the Middle East

Iran’s primary goal is regime preservation. It wants to end U.S. threats of regime change. This includes eliminating the long-term threat from a historically hostile Iraq. This concern is also why Iran appears to be undertaking a nuclear weapons program. As part of this goal, Iran also wants a stronger economy, which will likely require an ending of sanctions and higher oil prices. Its secondary goal is regional hegemony. It wants to dominate the Middle East, which will require at least a partial withdrawal from the region by the U.S.

Iran knows it faces opposition from the Sunni powers in the region and from Israel. In general, it has little interest in invading Saudi Arabia or attacking elsewhere; in fact, Iran tends to operate covertly and does not have a very strong conventional military. But, in the absence of the U.S., Iran will almost certainly become the dominant power in the region.

America’s Alternatives

After the loss of Iraq as a balancing power, the U.S. has three unpalatable choices. First, it can remain the balancing power in the region by adding military forces. In fact, invading the area currently controlled by Islamic State (IS) and carving up Iraq into Sunni and Kurdish zones would be a reasonable outcome and would likely create American bases of operation. It would thwart Iran’s expanding influence into Lebanon and what remains of Syria and reassure the Emirate States, Jordan, Turkey and Israel that the U.S. intends to stay. Unfortunately, such a plan will be very costly and tie up resources that may be better spent elsewhere. For example, taking this step would probably prevent the U.S. from actively curbing Russian ambitions in Europe and Chinese expansionism in the Far East.

The second option would be to foster another Middle East war, this one a religious conflict between Sunnis and Shiites. This is a frighteningly risky strategy. For example, what if IS or a similar radical Sunni group becomes dominant? What if Iran wins? There is no guarantee that the conflict would remain contained and oil flows would likely be interrupted.
The third option is to let Iran become the dominant power in the region. This would reduce costs to the U.S. and could likely bring stability to the region. However, there is no guarantee that Iran would be an effective or benign hegemon. We would expect the Emirate States to come to arrangements with Iran but other groups or nations may be less likely to play along. Turkey, for example, may be inclined to oppose this decision; Israel will as well. In the short run, Iran

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