Economics vs geopolitics: does the wolf finally bite

The stakes are higher this time around

It is true that a sudden reversal and US exit from the conflict can't be ruled out. President Trump has the personal audacity (or "chutzpah") to declare victory at any time, whatever the reality. But in this case, the political and security costs of a backdown are far greater.

Let us say that the US withdraws while the Strait of Hormuz still remains closed and without a clear 'prize', such as some form of regime change. The Iran regime (and its proxies) will be emboldened. More importantly, their defensive strategy will be validated. This strategy is based on:

• raising the economic and political cost of the war by cutting shipping through the Strait of Hormuz;
• applying regional pressure by striking US bases and allied infrastructure in neighbouring countries; and
• attacking highly visible and symbolic economic targets such as major international airports in the Gulf.

If the US withdraws it will be a concession that this strategy works. This will invite further Iranian attacks on US allies and interests; severely limit US leverage in any future negotiations with Iran, including over their nuclear program, and likely drive more oil supply disruptions over time.

The security officials in Washington (and Israel) are acutely aware of this, so they will want a more decisive outcome. They will want to prove to the world that they can underwrite safe transit through the Strait and/or win a more decisive military or political victory. As Madison Cartwright argues , this won't come easily. Even if it can be achieved, it will take time.

Holding back the tide

Noting the need for a more decisive military outcome, and the reality that this will take some time to achieve, what can the US do in the meantime to reassure markets and limit the near-term economic damage?

• They can 'jawbone' by talking up their military achievements and flagging an early or imminent end to the war.
• They can work with allies to release oil stockpiles and increase supply where possible, including easing Russian sanctions.
• They can focus their efforts on securing shipping access through the Strait by degrading Iran's offensive capability and increasing naval assets in the region to assist with escorting vessels.

This is exactly what the US has been doing. These actions, particularly the recent decisions to ease sanctions on Russian oil, confirm that the US is expecting a longer, and more drawn-out conflict.

Will the dam break?

To date, this strategy has prevented larger increases in the oil price and kept a lid on broader financial market damage. However, if as expected, the war drags on, we expect this strategy will wear increasingly thin. We therefore judge there is a strong likelihood of a further material market reaction in coming weeks - this could occur suddenly or gradually.

Furthermore, the longer the war lasts, the greater the risk of an accident or an escalation, such as the destruction of essential oil and gas infrastructure like a major processing facility, tanker terminal or pipeline. Any damage done to a US escorted vessel would also dent market confidence. These would spark a more sudden reaction across financial markets.

We have just seen an example of this with the recent air strike on Iran's South Pars gas field, the largest natural gas field in the world, driving retaliatory attacks on the Ras Laffan LNG Hub in Qatar, the world's largest LNG production/export complex. This saw Brent oil spike closer to $US120 a barrel before retracing back towards $US110 a barrel.