Iran's Blues

When the last U.S. troops officially left Iraq on December 17, 2011, it seemed Iran was the big winner. Iraq was being ruled by a Shiite coalition. Its military was weak and no longer a threat to Iran. Along with its ally in Syria and its proxy Hezbollah in Lebanon, there was growing talk of a “Shiite Arc” that ran from Iran to the Mediterranean Sea. Although Western sanctions were in place, Iran had become adept in working around them.

A bit more than a year later, Iran’s situation has deteriorated. Bashar Assad is barely holding on to power in Syria. In Iraq, PM Nouri al-Maliki has become difficult to control, and sanctions have turned out to be more powerful than expected. Overall, Iran is starting to see what appeared to be a dominant position slip away.

In this report, we will examine the situation in Iraq, the issues with Syria and the growing risk of Shiite-Sunni sectarian conflicts on a regional scale. We will include comments about the bilateral talks between the U.S. and Iran. As always, we will conclude with potential market effects of this evolving situation.

The Problem of Managing Iraq

Although the Sunnis were a minority in Iraq, due to the machinations of the British colonial rulers, they dominated the government. Baathist Party leaders, especially Saddam Hussein, oppressed the Shiites to prevent them from using their majority status to dominate the country. Complicating matters for the Shiites was the Iraqi invasion of Iran in 1980. Although ethnically different from Iran (Shiite Iraqis are mostly Arab whereas Shiite Iranians are mostly Persian), the Iraqi attack on Iran, over time, began to be seen in sectarian terms.

Iraq was Iran’s primary enemy, especially while governed by Saddam Hussein. Not only did Hussein invade Iran, he oppressed their sectarian brothers. Iran was officially neutral during the first Iraq War; however, it did tend to offer some support to Iraq. For example, Iraq tried to protect some of its warplanes by flying them into Iran. Saddam Hussein gambled that the U.S. and its allies would not attack these aircraft while sitting in Iran for fear of drawing Iran into the conflict. Iran did allow the planes safe harbor in its nation; Iran’s official policy was to hold any aircraft that landed in its territory until the end of hostilities. However, after the war, Iran never returned Iraq’s aircraft.

The 2003 decision by the U.S. to remove Saddam Hussein from power was greeted with support from Iran. Although they did not officially join the “alliance of the willing,” Iran made it clear that airmen from the coalition that ended up on Iranian soil would be cared for and returned. For Iran, the removal of Saddam Hussein from power was a major benefit. And, the Bush administration’s almost religious affinity for democracy was seen as supportive as well, given that the Shiites were a majority in Iraq.

As the U.S. began the painful process of creating a democratic government in Iraq, Iran was supportive. Shiite insurgent activity, which was mostly led by Muqtada al Sadr, the son of a renowned Shiite cleric, was kept to a minimum. On the other hand, Iran wanted to see the U.S. bogged down in a messy counterinsurgency war. There is evidence that Iran supplied Sunni insurgent groups with weapons. Overall, Iran was banking on a democratic outcome that would favor the Shiites and, by default, Iran.

For the first three years after the U.S. incursion, this was the case. The U.S. tended to support the Shiites and viewed most Sunnis as hostile; many were holdovers from the previous regime. However, in early 2007, President Bush decided on a high risk strategy, described as “the surge,” which added 20,000 troops to Iraq. As part of the surge, Gen. David Petraeus, a counterinsurgency expert, was named Commander of the Multinational Force - Iraq. The combination of additional troops helped, but perhaps the most important accomplishment was Petraeus’s ability to turn the indigenous Sunni insurgency against outside jihadists fighting in Iraq. In rapid fashion, the unruly Anbar Province was brought under control.

Although it was good news for the U.S. and its allies, it was unwelcome for Iran. Not only did the surge reduce the violence facing the allied troops, it gave the Sunnis political power. Iran began to give more support to any insurgency in Iraq but, for the most part, the surge brought Iraq under control.

Iraq has had two elections since 2005. In both, Shiite parties have formed majority governments led by PM al-Maliki. Thus, since the inception of Iraq’s democracy, there has not been a change in government. This suggests the political system is not very robust and indicates to those outside the ruling coalition that they have little chance of having influence.

Al-Maliki has two primary objectives—thwart any Sunni attempts at regaining power and ensure that his “State of Law” coalition remains in place. From the prime minister’s perspective, both goals are mutually dependent. Al-Maliki assumes that if his party loses power then a Sunni coalition will probably end up in control. If this is true, then it would follow that al-Maliki should do everything possible to remain in power.

The elections in 2010 showed the weaknesses of his program. Although the State of Law coalition is non-sectarian and has some Sunni groups in it, it is primarily Shiite. The Iraqi National Movement, another non-sectarian party (but mostly Sunni) led by former interim Prime Minister Ayad Allawi, won 91 seats in the Iraqi Parliament, compared to 89 for the State of Law coalition. In the nine months that followed, Allawi’s coalition began to fray as smaller parties left and joined al-Maliki’s coalition. Still, even with these defectors, al-Maliki was forced to form a government by accepting the Iraqi National Alliance party, a Shiite sectarian group. This party included Muqtada al-Sadr’s followers. From there, the State of Law party maintained control.

After the last U.S. troops left Iraq, al-Maliki moved rapidly to confront his political opponents, accusing the country’s highest ranking Sunni official, VP Tariq al-Hashemi, of orchestrating large scale terrorist attacks. Al-Hashemi escaped capital punishment by first seeking refuge in the Kurdistan region and going into exile in Turkey. Although his attempted arrest did not raise serious hackles among the Sunni (turns out he wasn’t very popular), the fact that he was able to find sanctuary in the Kurdish region speaks to how divided Iraq is becoming.

Early last year, al-Sadr threatened to join forces with Sunnis and Kurds and bring a no-confidence vote against al-Maliki. Al-Sadr would like to replace al-Maliki but the former is seen around the world as a sectarian leader. Iraq controlled by al-Sadr would struggle to work with other world leaders. In addition, al-Sadr is a divisive figure among Shiites; he is not liked at all by Sunnis and Kurds. Thus, a no-confidence vote could trigger significant political unrest. With Iran’s help, al-Maliki was able to quell the threat.

However, this narrow escape did nothing to make the prime minister more cautious. Last December, he arrested members of the security detail of his finance minister, a prominent Sunni named Rafi al-Issawi. Unlike al-Hashemi, al-Issawi is popular among Sunnis and the arrests led to massive protests from the Sunni community. These protests demonstrate al-Maliki’s mishandling of the Sunni opposition, but even his Shiite allies are becoming uncomfortable with the prime minister’s authoritarian behavior. In response, the Iraqi parliament passed a bill on January 26th that put a two-term limit on prime ministers. Al-Maliki is fighting the law in the courts. However, to remain in power he must adjust his behavior. Of course, as noted above, al-Maliki believes that if he loses power, then the Shiites will too, which likely leads to his behavior.

Iran wants a Shiite-dominated government in Iraq that will not project power against its neighbors and will act as a reliable ally in Iran’s quest for regional domination. Instead, in al-Maliki, they are getting a strongman who consistently overestimates his power and, in the process of creating his own powerbase, is causing what Iran perceives as unnecessary tensions. Iran does not want to see Iraq break up into sectarian and ethnic regions. Such an outcome would likely lead to the Sunnis controlling western Iraq and the Kurds holding northern Iraq. This situation would surely disrupt the “Shiite Arc” that Iran has been trying to craft. Al-Maliki is becoming unreliable but there is no workable replacement that would support Iran’s goals. Thus, Iran is stuck with a somewhat friendly government in Baghdad that is threatening to create a situation that could be disruptive to Iran’s goals and aspirations.

The Problem of Syria

Syria under the Assads has been a reliable ally of Iran. Because of Syrian influence in Lebanon, the relations between Syria and Iran are important. This is because it is through Syria that Iran influences Hezbollah, its ally in Lebanon.

When the uprising in Syria began in March 2011, it appeared to be a series of minor protests. However, the Assad regime seriously mishandled the situation which prompted widening protests that eventually evolved into a full-blown insurgency. Although the Syrian opposition remains hopelessly divided, jihadist elements have joined the fight and have proven to be effective fighters.

As is the case with many authoritarian governments, the Assads governed by pitting various groups against each other. Minority Alawites (a sect of Shiism) and Christians were put against the majority Sunnis. The Assads would offer favors to groups to build allegiance and make them dependent upon the regime. At the same time, they would deny economic assets to other groups. This pattern is one of the reasons why the transition from authoritarianism to democracy is so difficult. Various groups see others as either a threat to their current status or as preventing them from getting what they rightfully deserve. And so, when democratic governments replace authoritarian ones, previously favored groups are terrified of losing their status and do everything they can to keep it while persecuted groups are out to claim what is theirs at the expense of others. Compromise is rarely employed; it is seen as being weak.

At present, Syria is on its way to becoming a failed state. It isn’t clear if the Assad regime controls very much of Syria anymore. Instead, power appears to be distributed among a number of warlords. Like the Lebanese civil war, which ran for nearly 15 years (1975-90), Syria is in danger of endless conflict.

Iran is clearly worried about its Syrian ally, so much so that it reiterated its mutual defense pact and went so far as to say that “an attack on Syria is an attack on Iran.” This was to serve as a warning to outside powers not to intervene and push Assad out of power. So impressed were the Israelis that they promptly attacked a suspected weapons caravan on Syrian soil. Iran does possess significant asymmetric military assets but its conventional forces are relatively small. Thus, defending Syria against a conventional attack is unlikely.

If the Assads lose power in Syria, which appears likely, Iran will lose a key ally in the region. Most importantly, it will lose its direct contact with Hezbollah.

The Sunni Resurgence

Not so long ago, it appeared that Iran was going to establish the aforementioned “Shiite Arc” from Iran to Lebanon. However, as we noted above, this arc is facing serious threats. In fact, Iran is worried enough that it apparently has been trying to make overtures to the Saudis in an attempt to thwart “sectarianism.” On January 23rd, the day most Muslims celebrate the birth of the Prophet Mohammed, Iranian Brig. Gen. Hassan Firouzabadi called for “Islamic unity.” Later in his comments, he lamented the fact that al Qaeda and other jihadist groups, initially formed to attack the “infidels,” were being turned against other Muslims and have become a “tool” of the enemies of Islam. The general was referring to the increase in jihadist groups operating in Syria. This comment was a thinly veiled criticism of Saudi support for these jihadists groups.

Recently, Iranian officials have been calling for a negotiated settlement in Syria. Saudi Arabia scotched the idea, suggesting that a political resolution was unlikely. Iran sees Saudi support for jihadists groups as creating conditions for a regional sectarian conflict, Shiites versus Sunnis. The non-sectarian groups fighting in Syria, who enjoy support from the West and Turkey, merely want to get rid of Assad. At this point, Iran would probably go along with this outcome if its interests were protected. The Saudis (and other Gulf monarchies) see the necessity of ensuring that a Shiite-dominated government does not emerge in Syria. And so, they have been supporting jihadists groups who are willing to take the fight against non-Sunnis.

For the West, this raises a difficult problem. The West would like the next Syrian government to be aligned against Iran. However, if the cost of that outcome is a foothold for al Qaeda-like groups, ousting Assad looks less attractive. If the U.S. is reducing its footprint in the region, it will be harder to direct the outcome in Syria and a hostile jihadist state could develop. For the Saudis, the goal is to turn back Shiite gains seen since the Iraq War. A jihadist state may be an acceptable consequence.


Iran has been under some form of economic sanctions for years. The U.S. put Iran under sanctions soon after the U.S. Embassy was attacked and Americans were held hostage. These sanctions waxed and waned due to the conditions of bilateral relations between the U.S. and Iran.

However, as evidence mounted that Iran was enriching uranium, sanctions became broader and more effective. Perhaps the most effective actions have been against Iran’s banking system. Iran has lost its ability to use the S.W.I.F.T. network which banks use to facilitate international transactions. This makes it difficult for Iran to purchase imports or sell oil. Adding to these sanctions were Europe’s oil import embargo against Iran and the suspension of insurance for Iranian oil carrying tankers. As a consequence of these actions, Iranian oil production has plummeted.

This chart shows Iran’s oil production. Last year, as sanctions were implemented, Iranian production declined sharply. Since oil is the lifeblood of Iran’s economy, sanctions are putting a serious dent in growth.

Talks with the U.S.?

Recently, Vice President Biden indicated the U.S. was willing to engage in bilateral talks with Iran over its nuclear program. Iran appeared open to the possibility. Most likely, the Obama administration offered to talk because Iran is in a difficult spot; essentially, the U.S. should have the upper hand in talks given Iran’s current predicament.

For Iran, talks are fraught with risk. If the U.S. is still harboring ideas of an attack on Iran’s nuclear industry (which we doubt), failed talks would improve the administration’s ability to justify an attack. Simply put, if talks fail, the U.S could say that it had done all it could to resolve the nuclear situation in Iran diplomatically and military action is the only remaining option. We note that Ayatollah Khomeini recently rejected bilateral talks because he sees the weakness of Iran’s current position and does not want to engage the U.S. from this position. However, rejection could be interpreted as the same as failed talks. Thus, there is some risk in the ayatollah’s rejection.


Iran’s deteriorating geopolitical situation could lead to binary outcomes. If the pressure encourages the country to give up its nuclear program without a war, it is a major diplomatic win for the Obama administration and the West. Such an outcome would be bearish for oil prices as it would reduce the omnipresent risk premium.

However, if talks fail to make progress, not only does that outcome increase the chances of U.S. military action against Iran, but it may lead to a broader regional conflict. Saudi Arabia is clearly pressing to reverse Shiite gains that have evolved since 1979. If the Shiite Arc is broken, Iran may respond by unleashing an asymmetric conflict across the region.

For now, we will closely monitor the prospective talks between Iran and the U.S. If they fail, we would expect oil prices to rise on worries of regional unrest. Of course, if they are successful, then oil prices should decline.

Bill O’Grady

February 11, 2013

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

© Confluence Investment Management

© Confluence Investment Management

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