The Islamic Republic versus the Islamic Kingdom – is war inevitable?

On 14 September drones controlled by proxies of the Islamic Republic of Iran took out two important oil installations in the Kingdom of Saudi Arabia. Mr Trump is now sending US forces to the region. How will this all end? Victor Hill is asking.

Wars of the future

I have been arguing in these pages for some time that the next major conflagration will be triggered, not by a missile attack, but by a drone incursion. This is how military thinkers are planning wars of the future these days. After the drones take out key infrastructure, a massive cyber-attack will begin which will paralyse utilities. (The British Army now has 6 Division – a cyber-warfare unit.) Only in the third phase will missile strikes begin – to be followed by boots on the ground (though some of those boots will belong to robots).

We had a sneak preview of how a modern war might begin on 14 September. On that day an estimated 18 rogue drones took out two oil and gas stabilisation plants at Abqaiq and Khurais in Saudi Arabia’s Eastern Province. Both facilities are owned by Saudi Aramco. According to some reports, up to four cruise missiles hit targets too, in which case they would have left a signature visible from space which the Americans will have detected. It is odd that no cruise missiles were intercepted by Saudi’s state-of-the-art Patriot and Hawk missile defence systems supplied by the US. One theory is that Iran sent the missiles via a circuitous route through Iraqi airspace and then due south in order to avoid detection.

In one day, global oil capacity was reduced by an estimated 6 percent – that’s 5.7 million barrels per day, at a time when spare capacity is estimated at just two percent. According to Mike Pompeo, the US Secretary of State, the attack knocked out half of Saudi Arabia’s total production and it will take months to get back to full capacity.

The initial suspicion was that this was the work of Saudi’s bitter enemy, the Houthi rebels of Yemen. Yet, within a day, Saudi authorities were claiming that the drones had “come from the north”. Military analysts suggested that it is extremely unlikely that, if Yemeni-based adversaries were responsible, they would have sent drones the 1,680 kilometres as the crow flies from Sanaa in the south-west to Abqaiq[i], crossing other Saudi oilfields (and indeed Riyadh) as they did so. That is pretty much impossible. The range of the type of cruise missiles that Iran commands is about 700 kilometres. The drones (and possibly cruise missiles) were most likely launched from vessels in the Persian Gulf or in Iran itself.

Over the following 24 hours, oil prices on the spot market rose by as much as 20 percent before stabilising. The value of shares in BP (LON:BP.) and Shell (LON:RDSA) rose accordingly. On Friday, 20 September, President Trump ordered US forces to deploy to Saudi Arabia to bolster the Kingdom’s air defences. The President said that there were many options short of full-scale war. But the Iranian foreign minister, Mohammad Javad Zarif warned in a tweet that any strike against Iran would result in all-out war.

The Iranian conundrum

Dealing with Iran is not straightforward because its government has two quite separate heads.

On the one hand, there is a seemingly democratic government, headed by a president who is elected by a popular vote (albeit that candidates have to be approved by the clerics). The current president, the seventh since the Islamic Revolution of 1979 and elected in 2013, is Hassan Rouhani who, amongst many other things, is an alumnus of Glasgow Caledonian University.

On the other hand, there is a level of government above the president headed by the Supreme Leader, who is always a senior cleric. Currently, it is Ayatollah Khamenei. He has ultimate religious, moral and political authority. Many government agencies and military units, most prominently the elite Republican Guard, report directly to him. The language coming from this part of government has become increasingly intransigent of late. The Ayatollah told the visiting Japanese prime minister in June that there is simply no point in negotiating with America.

Unlike with North Korea, where a tyrannous dictator can be coddled, there is no space in Iran for any kind of charm offensive. Even if President Rouhani were amenable to dialogue he would most likely be over-ruled by the Supreme Leader. American and Iranian leaders have not met for over 40 years.


It is significant that President Trump relieved his National Security Advisor (NSA), the notoriously hawkish John Bolton, of his duties on 10 September – just days before the drone attack in Saudi Arabia. Mr Bolton once authored a column entitled “To Stop Iran’s Bomb, Bomb Iran”. Mr Bolton was succeeded on 18 September by Robert C O’Brien, a lawyer who has previously compared Mr Obama’s 2015 Iran deal to Neville Chamberlain’s 1938 Munich Agreement by terms of which the Nazis seized control of Czechoslovakia. In his book While America Slept, Mr O’Brien excoriated Mr Obama for leading from behind. Mr O’Brien, a Mormon, is Mr Trump’s fourth NSA.

On Tuesday (24 September) President Trump, in his address to the United Nations General Assembly, warned that Iran would pay a high price for any further aggression. British Prime Minister Johnson did have a brief meeting with President Rouhani that day during which he apparently communicated his concerns.

Yemen: the mote that is in thy brother’s eye

Years ago, I asked a senior Saudi official if he envisaged that Yemen might ever join the Gulf Cooperation Council (GCC). He adopted a pained expression; then, after a pause, he said: “These are very primitive peoples”. Even though Yemen was a crucible of Arab civilization (its architecture is unique), the Saudis have regarded their southern neighbour as a rich landowner regards travellers at the gate.

Under the ascendancy of the Crown Prince, Mohammed bin Salman (“MBS”), Saudi Arabia has become deeply embroiled in an intractable civil war between Yemen’s traditional ruling elites and the Houthi rebels. The latter are aligned with the Shi’ite tradition and have almost certainly been championed by the Iranians. As this nasty conflict has proved more internecine, so Saudi Arabia has taken the gloves off and inflicted indiscriminate civilian bombing with undoubtedly awful humanitarian consequences. Their justification is that, since seizing the Yemeni capital, Sanaa, in 2014 the Houthis have fired scores of missiles into Saudi Arabia, killing more than 100 people.

As a result, the Houthis and their sponsors have resorted to more extreme methods. Even the United Arab Emirates (UAE), a close ally to Saudi Arabia, has warned that Dubai and Abu Dhabi might now be subject to attack. That could shatter those two cities’ status as business and tourist hubs. Dubai has one of the world’s busiest airports with more traffic than either London’s Heathrow or New York’s JFK. In November next year Riyadh will host the G-20 summit – unless events determine otherwise.

The fate of the deal

President Obama’s July 2015 nuclear deal with Iran, enthusiastically supported by the Europeans, was junked by President Trump in May last year. Since then, the Americans have vigorously reinstated sanctions which are now costing Iran the export of two million barrels of oil a day – and they have arm-twisted their friends and allies into doing likewise. The hardliners in Tehran, who were always sceptical of the nuclear deal, rather than being bowed by renewed American pressure, have only retrenched in advocating renewed confrontation with The Great Satan.

America’s allies in the region – apart from Israel – are the Sunni monarchies of the Gulf. Namely: Saudi Arabia, Kuwait, Bahrain and the UAE (the latter being technically a republic whose president is a quasi-king). Qatar, while an Arabic Sunni monarchy, is inclined towards Tehran and has been ostracised by its Arab neighbours. The Sultanate of Oman is more in the Saudi sphere of influence; but three quarters of its overwhelmingly Muslim population adhere to the Ibadi School of Islam which is the subject of disapproval by orthodox Saudi Wahhabis. The Gulf Cooperation Council (GCC), which includes Oman (but of course not Yemen) is not a cohesive edifice, despite the pan-Arab rhetoric.

These predominately Sunni states increasingly see the Islamic Republic of Iran as a real and present danger. In contrast, because of Mr Trump’s hard line, the Europeans, led by the French, have argued in favour of a more indulgent stance towards Tehran.

Why this time could be different

The world has become inured to the endless war of words between Washington and Tehran that began way back in pre-history (1979, actually – when the new Iranian revolutionary government took American diplomats hostage). As a result, many analysts have concluded that such a war of words would not escalate into a war of missiles. But in June the backdrop changed when Iran’s Revolutionary Guard was accused by President Trump of perpetrating attacks on oil tankers in the Gulf.

Any war with Iran, which is a very substantial entity with a population of 83.5 million (more than twice that of Iraq), would be a momentous event. Iran has very considerable armed forces and is chummy with Russia from whom it sources advanced weapons systems. The Iranians have, according to the UK National Security Agency, one of the five top cyber-warfare capabilities in the world. They have electromagnetic pulse (EMP) weaponry which can paralyse infrastructure.

There is no way that a US surgical strike, even though America has massively superior firepower and technology, could result in a clean regime change. Rather, the country might fragment along sectarian lines, as Syria did. Iran could become a quagmire that saps US resources for years; and Shia elements within the GCC countries might be induced to revolt, causing huge instability for the Sunni monarchies.


What’s more, there would be massive dislocation of international trade, a huge spike in the oil price and, possibly, an energy crisis akin to that of the Great Oil Shock of 1973. There would very likely be a diplomatic rift between the USA and its EU partners in NATO (even Old Europe[ii] would object). (Britain, so long as the country is locked in its Brexit seizure, is effectively hors de combat, diplomatically speaking). Even the gung-ho Israelis understand that any military operation against Iran would be incredibly high risk – and Mr Netanyahu, Iran’s nemesis, may well be on his way out. As for Mr Trump, he doesn’t want anything to upset the New York markets before November 2020. That is probably the real reason why he fired Mr Bolton. Once re-elected, if that happens, Mr Trump will feel less constrained.

But on the ground, opinion is hardening. Just as the hardliners have gained ground in Tehran, so in Saudi Arabia, the 34-year-old Crown Prince, Mohammed bin Salman, has set Saudi Arabia on a much more belligerent course. Saudi’s arterial east-west oil pipeline was attacked by drones in May – so it has not been difficult to encourage a siege mentality in the desert kingdom.

Possible consequences

Any Oil Shock would accelerate the transition from petrol and diesel-powered vehicles to electric-powered ones, which is already underway. That, in turn, could trigger a rapid collapse in demand for oil which would trigger the demise of OPEC. Deloitte reckons that the purchase price of electric plug-in cars will fall to that of equivalent internal combustion engine vehicles by 2022. The cost of renewable electricity is falling fast – by as much as 30 percent since 2017 in the UK[iii]. Energy storage costs (i.e. batteries) are also falling rapidly. Therefore, the tipping point where electric cars will be preferred could be just 3-4 years away – much sooner than most analysts expect, as I recently explained in the September edition of the MI magazine.

Urban electric busses are already cheaper than their diesel equivalents. This is an important reason why Wrightbus, which makes London’s celebrated Routemaster busses in Ballymena, Northern Ireland, went into administration on Wednesday (25 September)[iv]. Shenzhen’s bus network is 100 percent electric and Shanghai’s is not far behind. London is behind, but moving in that direction.

Electrification is bad news for the likes of Saudi Arabia; but in the short-term the Kingdom would greatly benefit from a spike in the oil price. According to IMF data, the Kingdom’s fiscal break-even is $85 a barrel. This morning Brent Crude is trading at $62.22 which is roughly where we were in early July. The oil price rose by 35 percent between January and April this year – from around $55 to $75 – before falling back over the summer.

SenatorElizabeth Warren, a leading candidate for the Democratic presidential nomination, wants an immediate ban on fracking in the USA. That would reduce global oil supplies by nearly 9 percent overnight. The USA is now pumping more than 11 million barrels of oil daily, making it the global number one oil producer. China, in contrast, is hugely dependent on oil coming through the Straits of Hormuz.

Winners and losers

A new Oil Shockwould be quite survivable for countries like the UK which have burgeoning renewable energy sectors. In some ways we might look back on recent years and conclude that relatively “cheap” oil delayed the necessary transition to electric transport.

One beneficiary of the rising geopolitical risk is gold, which surged above the $1,500 mark for the first time since 2013. Specialist energy funds such as BlackRock World Energy have done well, as have broader funds exposed to the oil sector such as Aberdeen Standard Investments UK Recovery.

Commodities, as a sector, are on the up – especially niche categories such as rare Earth elements which include antimony, magnesium, tantalum and tungsten amongst others.


Let’s not forget also the outlook for drones themselves. The market for these extraordinary devices is now worth $127 billion a year – they are deployed in everything from farming, policing and entertainment to defence. The EU has recently backed the €10 million Roborder project which will use drones to monitor immigration hotspots. Solar powered drones currently in development by BAE Systems (LON:BA.) will be able to stay aloft for an entire year. This means that drones can undertake tasks currently undertaken by satellites – but much more cheaply. US defence contractors Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), and Boeing (NYSE:BA) manufacture most of the military drones used by the US armed forces.

Conversely, shares in travel companies have fared badly. Airlines and cruise operators like Carnival (NYSE:CCL), which owns amongst many other brands P&O Cruises, are well down. As we know, Thomas Cook, already on the brink, gasped its last on Monday (23 September).

Scenarios

The worst-case scenario is that an all-out war with Iran and a resulting oil shock coincides with an intensification of the US-China trade war (China’s stance on trade would harden), acceleration in the global economic slowdown, meltdown in the emerging markets and a financial crisis in the eurozone. Crises, like London busses, normally come in threes. That is when the only sure-fire refuge would be gold as everyone gets out of equities at once. $2,000 an ounce would be quite feasible.

War between the Kingdom and the Islamic Republic is not inevitable, though quite possible. That concatenation of crises is not very likely to occur in the short-term. But you never know. Let’s hope for the best but prepare for the worst.

***

I much enjoyed our Chairman’s most recent Mellon on the Markets column (to be re-printed in the October edition of MI magazine). Jim is right that the whole world right now – not least the millenarian young – seem to be in a state of extreme indignation (and not just in Brexit-paralysed Britain). This is odd when one considers that we, as a society, are probably richer and healthier than at any time in human history, have more leisure time and own more toys…

Very few, if any, of the Extinction Rebellion demonstrators has ever been hungry or severely cold. (I doubt that they have reflected on that.) And they don’t seem to understand that civility is a hugely important social good, one from which the British profited for centuries – though which is now, sadly, in precipitous decline. Moreover, if I may say so, they could start to save the planet by taking their litter home with them…

I keep wanting to share with them my Victorian grandad Bert’s favourite homespun wisdom: Count your blessings; waste not, want not; action speaks louder than words; beggars can’t be choosers; the early bird catches the worm; God helps those who help themselves…

The Society for the Preservation of Sensible Proverbs? Anybody?…Never mind.

Victor.hill@masterinvestor.co.uk

[i]Check it out on Google Maps.

[ii]Donald Rumsfeld’s term for the EU’s eastern European members.

[iii]Based on the recent auctions for four wind farms on Dogger Bank which envisage a strike price of £39.65-£41.61 per megawatt hour.

[iv]See: https://www.bbc.co.uk/news/uk-northern-ireland-49818156