Reflections On The Iran Deal by Bill O’Grady of Confluence Investment Management

Last month, the P5+11 and Iran concluded negotiations on a nuclear deal. In this report, we will offer some reflections on the agreement, including why it occurred, and the major reason why the U.S. negotiated this agreement and the underlying issues. As always, we will conclude with market ramifications.

Why a Deal was Reached

An agreement occurs because parties to it have reasons for making it. How good the deal is depends upon the starting positions, who needs the deal more and how well they negotiate.

The U.S. has been continually involved in the Middle East since WWII. From the time President Roosevelt and Saudi King Ibn Saud met in Egypt on Valentine’s Day, 1945, to the present, the U.S. has had interests in the region. The primary American goal was to prevent any other power from gaining significant influence. Mostly this was done to prevent the U.S.S.R. from spreading communism in the region and deny the Soviets a warm water port. As the area’s oil production rose, the U.S. wanted to ensure the security of energy supply from the region.

The U.S. engaged in the region in a number of ways. In 1953, the U.S. covertly participated in a coup against Iranian PM Mohammad Mosaddegh to prevent him from nationalizing the Anglo-Iranian Oil Company and perhaps creating conditions for communist infiltration. In the 1956 Suez Incident, the U.S. made it clear to former colonial powers, France and Britain, that their interference would not be tolerated. U.S. support of Israel increased significantly after France withdrew its support after the Six-Day War. Nixon’s decision to resupply Israel during the Yom Kippur War led to the Arab Oil Embargo. The U.S. implemented sanctions against Iran after the Shah was overthrown in 1979 and the new regime held Americans hostage. America supported both sides, at different times, during the Iran-Iraq War. After the Cold War ended, the U.S. ousted Saddam Hussein from Kuwait and enforced a no-fly zone and sanctions against Iraq. Under President Clinton, the U.S. attempted to isolate both Iran and Iraq through sanctions and other means.

Global superpowers often control regions by creating a balance of powers in various regions. The British were very adept at such actions; the U.S. was less so, but because America’s economic might dwarfed Britain’s, the U.S. was still able to manage the world. In Europe and Asia, the U.S. simply dominated both regions, preventing pre-WWII powers from recapturing their powerful pre-war positions. In the Middle East, the U.S. tended to manage the region through strong relations with Israel (at least during the Cold War) and balancing power between Iran and Iraq.

President Bush’s decision to oust Saddam Hussein in 2003 was based on the assumption that the U.S. would be able to create a strong and friendly government to replace the mercurial Hussein. The thinking behind this idea suffered from serious flaws; the most critical was not understanding the sectarian divides in Iraq. Ousting Hussein was a direct threat to the minority Sunnis and building a new government with Iraqi Shiites was likely to create one sympathetic to Iran, which is exactly what occurred. A civil conflict emerged; the U.S. was able to temporarily end it by supporting Sunni tribes as part of the 2007-08 “surge” but a unified government never emerged. The country appears headed toward a breakup into Sunni, Shiite and Kurdish regions.

American and Iranian Goals

The U.S. has three goals in the Middle East. First, it wants a free flow of oil out of the Persian Gulf. It won’t tolerate any power interfering with oil flows. Second, it won’t allow a single power to dominate the area around the Persian Gulf, because it would make that nation very powerful. Third, it needs to accomplish these two goals as economically as possible. The U.S. is a global power. It has responsibilities in other parts of the world and cannot devote excessive attention to the Middle East without increasing the risk of other areas becoming unstable.

Iran’s primary goal is regime survival. Its second goal is that Iraq will never be a threat to the regime; in other words, Iran will not tolerate a repeat of the Iran-Iraq War. Third, it wants to represent and defend Shiites across the region.

When President Obama took office, he faced a difficult set of circumstances. Iran had a nuclear program going back to the days of the Shah, but was accelerating it after the ouster of Saddam Hussein. After all, Iran was a member of President Bush’s “axis of evil” and felt that the best guarantee that the U.S. would not try to invade Iran was to be a nuclear power. The war against Muammar Gaddafi in Libya after he had given up his nuclear program appeared to support Iran’s need for a nuclear weapon.

The administration had two options to prevent Iran from developing a bomb. The first was to develop sanctions so crippling that Iran would capitulate and give up its program. Getting a significant number of nations to maintain sanctions is difficult. There is always an incentive to cheat. The second was to use military force to eliminate the nuclear threat, which increased the risk of a full scale invasion of Iran and the overthrow of the government.2 Neither option looked appealing. The sanctions route was taken, although the president made it clear that he was open to negotiations unlike the Bush administration’s stance.

President Obama’s goal has been to “pivot” in order to focus on other parts of the world. To do this, the U.S. needs to reduce its exposure to the Middle East. The need to increase American “bandwidth” is important and not generally recognized. It is worth noting that as the U.S. became bogged down in Iraq, Russia has invaded Georgia and recently moved aggressively into Ukraine. China has become increasingly aggressive in the South China Sea. So, being able to reduce American forces in the Middle East would be useful in that it would allow the U.S. to act against Russian and Chinese aggression in other parts of the world.

Although the chances of adding more sanctions looked low five years ago, the aggressive behavior of Iranian President Ahmadinejad allowed the U.S. to push through a broad set of sanctions. The U.S. was able to put an oil embargo on Iranian sales to Europe and the administration was also able to remove Iran from the S.W.I.F.T. network, effectively cutting Iran out of the global financial system. The administration was successful in ratcheting up sanctions because it had a definitive purpose—managing Iran’s nuclear threat. It is doubtful that purely open-ended sanctions, with the purpose of regime change, for example, would have been widely adopted. In fact, they probably would have never emerged from the U.N. Security Council.

These sanctions steadily pressured the Iranian economy. The election of President Rouhani in 2013 signaled that Iran was probably open to negotiations. Although it took two years, a deal was reached.

Essentially, the deal that was struck will make it difficult for Iran to build a bomb for 10 years. An inspection regime will be in place; although no inspection program is perfect, this one should make it hard for Iran to build a

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