The Evolution Of Islamic State by Bill O’Grady of Confluence Investment Management
(Next week we will publish our Geopolitical Outlook for 2016. It will be our last issue of 2015.)

An Islamic State (IS) affiliate downed Russian Metrojet Flight 9268 in October. In November, IS-affiliated terrorists launched a series of attacks in Paris. These two events suggest a significant change in the behavior of IS. Prior to the Paris attacks, Islamic State  appeared to be focused on building a caliphate in Syria and Iraq. The shift to terrorist acts suggests a new strategy.

In this report, we will recap the two strategies radical jihadists have employed against the West, highlighting the differences between al Qaeda and IS. We will examine the current stalemate that exists in the area IS currently controls and how Islamic State  may adjust its future strategy. As always, we will conclude with potential market effects.

Islamic State – The Basic Strategies

There has been a persistent debate among Islamic extremists about the most effective way to create the caliphate, the true physical state of Islam.1 Osama bin Laden believed that the best way to re-create the caliphate was to develop conditions that would lead to the spontaneous overthrow of corrupt nations in the Middle East. He believed that these puppet states would collapse if the West withdrew its support, and so he focused al Qaeda on attacking the “far enemy.” A series of attacks against U.S. targets culminated in the horrific events of 9/11. Bin Laden believed that the West would either not retaliate from these steadily escalating strikes and show themselves as weak, or wildly retaliate and reveal that the West’s true agenda was another crusade against Islam. In either case, bin Laden assumed that local Muslims would rise up against their corrupt leaders and oust them from power, creating conditions for alQaeda leadership to enter and create the caliphate.

The other position argued that attacking the West was folly and that the best way to create the caliphate was to simply create an Islamic state. Once the caliphate was declared, it would be the duty of all observant Muslims to join the effort to relentlessly spread the new nation’s boundaries until it was the only nation in the world.

Bin Laden’s assessment of the West’s reactions was generally accurate. The Clinton administration mostly failed to react to the attacks on the U.S. embassies in Nairobi and Dar es Salaam in 1998 and the attack on the U.S.S. Cole in 2000. The lack of action suggested the U.S. would not necessarily support its “puppets” if attacked and, in fact, local branches of al Qaeda began springing up on the Arabian Peninsula.2 After 9/11, President Bush reacted strongly to the attacks on New York and Washington by ousting the Taliban in Afghanistan and invading Iraq. Bin Laden argued that this was clear evidence of a new crusade against the Islamic world; however, his hope for spontaneous uprisings failed to develop. Al Qaeda’s leadership found itself bottled up in the mountains of Afghanistan, facing constant attacks from drones and becoming increasingly irrelevant. In May 2011, Osama bin Laden was killed by a U.S. Navy SEAL team.

Islamic State  emerged from the local al Qaeda affiliate in Iraq that was run by Abu Musab al-Zarqawi. Al-Zarqawi was a controversial figure among jihadists. He had numerous disputes with al Qaeda’s leadership over his methods, which included terrorist attacks against Shiites and Sunnis that al-Zarqawi deemed not adequately fervent. The leadership in Afghanistan did not want al-Zarqawi attacking other Muslims regardless of belief and tried hard to rein in this rogue leader. Al-Zarqawi was killed by a U.S. airstrike on June 6, 2006. In 2007, President Bush ordered the Iraq Surge. Gen. David Petraeus implemented a counterinsurgency strategy that effectively destroyed much of the support for al Qaeda in Iraq. Sadly, the sectarian policies of Former Iraqi PM Nouri al-Maliki, who treated Iraqi Sunnis as a threat, and the premature withdrawal of U.S. troops by President Obama squandered the gains from the surge.

In this maelstrom of Sunni discontent, Islamic State  was born. Built mostly from the remnants of al Qaeda in Iraq, the group, led by Abu Bakr al-Baghdadi, took the opposite approach of bin Laden and worked to create a local state, effectively erasing the border between Syria and Iraq.

The initial success of Islamic State occurred for four reasons. First, it was able to hold Sunni areas in Iraq and Syria. We doubt many of the locals are enamored with the brutal state that IS created; however, even Islamic State was considered a better alternative to being subjugated by the Shiites in Baghdad or the Alawites in Damascus. Second, unlike the stateless al Qaeda, IS was able to acquire economic resources through conquest. It has several sources of revenue, including selling oil (some sales are to areas of Syria either under the control of Bashar Assad or opposition groups),3 selling antiquities, confiscating assets from captured banks, levying taxes on local areas under its control and collecting ransoms from kidnappings. Thus, it was able to pay fighters for their services, in many cases, better than other insurgent groups. Third, the emerging proto-state also benefited from Muslim foreigners attracted to the notion of the caliphate. A steady flow of fighters came from all over the world to help build the new caliphate. Fourth, IS benefited from the lack of focus from potential enemies, both near and far.

Islamic State – The Problem of Priorities

The fourth point is critically important. Although there is no established nation that would consider IS an ally, there are no states that view its removal from power as its top priority.

United States: Although the Obama administration would like to see Islamic State destroyed, it also wants to see Assad removed from Syria. Destroying IS would likely allow Assad to remain in power. At the same time, eliminating IS will create a power vacuum in the region with an indeterminate outcome. And so, for the lack of a better alternative, U.S. policy has evolved into the containment of IS.

Turkey: The Erdogan government has two priorities, removing Assad from power and preventing the Kurds from developing a state. Although it would like to see IS eliminated, Turkey’s focus on its priorities has lead Turkey to be somewhat supportive of Islamic State by allowing foreign fighters to move across its borders and occasionally attacking Kurds aligned against IS. Vladimir Putin has accused Turkey of buying IS oil as well, although that hasn’t been confirmed. Russia: Putin’s primary goal is the survival of Assad in Syria. Russian airstrikes have mostly focused on non-IS groups trying to oust the Syrian regime. Attacking Islamic State appears to be a lower priority, even after the downing of Flight 9268.

Syria: Assad is mostly concerned about groups working to overthrow his government and has refrained from attacking Islamic State directly. IS has reciprocated by attacking the same groups that Assad has been fighting. In addition, as noted above, Syria has been buying oil and petroleum products from Islamic State.

Iraq: Although Baghdad

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