Crude prices are holding steady — after briefly soaring to a more than 3-month high in the aftermath if the assassination of a top Iranian general — amid ample supply and dissipating war fears.

President Trump’s decision to authorize the killing of Iranian General Qassem Soleimani has undoubtedly raised geopolitical risks. But, more importantly, there are two reasons why this matters for the economic outlook: oil prices and Trump’s decision-making processes. And even as political stresses wax and wane, oil has reached our estimate of fair value.

When political risk rises in the Middle East, oil prices rally. As news broke of Soleimani’s death, Brent crude rose from $66.50 to an intra-day peak of $69.70, and as high as $71 a day later. A $10 jump matters for the global outlook, but only if higher prices last longer than a few days. Recent events — including the September drone attack on Saudi Arabia’s oil facilities — suggest prices usually slip back. The upward momentum rarely turns into sustained supply disruptions. Oil producers outside the Middle East, and OECD nations can, and do, release oil from their stockpiles if global exports are threatened.

Calculating the impact on growth

Still, there could be a significant supply shock if the United States and Iran enter a full-scale war that disrupts output and shipping in the Strait of Hormuz. Most analysts think it is unlikely Iran will provoke a war that it will certainly lose, and the United States’ appetite for another Mideast adventure is limited. Short of a full-scale war, two scenarios may affect oil supplies: Iran could use its military or proxy groups to strike oil infrastructure, and there could be disruptions in Iraq’s oil production.

Iraq is in the middle of the conflict between the United States and Iran. Its Shia population is drawn to Iran, and the United States has worked to keep Iraq out of the Iranian orbit. The mood in Iraq is grim, and it’s easy to see a return of instability, which would threaten crude output from its southern oil fields. Under these scenarios, the key question for the global outlook is how the events will affect oil prices and for how long. We think further spikes are highly likely as we expect periodic deterioration in Iran–U.S. relations.

But short of an all-out war, we struggle to see any significant damage in oil export capacity that will have a lasting impact on prices. There is tail risk that a major military conflict between the United States and Iran could push prices higher over the long term and hurt the economic outlook. This is not our central scenario. Also unlikely is the opposite outcome — that U.S. military action destabilizes Iran and creates a new government that would allow the United States to lift sanctions, leading to a dramatic rise in Iranian oil exports.

Oil's fair value drifts lower

Fair value edges lower

The steady upward drift in oil prices in November and December brought them to our fair value estimates before the spike driven by renewed tensions between the United States and Iran. Fair value has drifted down over the course of this year. The underlying story remains one of OPEC+ needing to restrain output to keep prices where the bloc wants it. The outlook suggests there will be some difficult talks within OPEC about another extension in the coming months.

In terms of the ongoing hostilities between the United States and Iran, it’s hard to know, from day to day, how the mood in Washington and Tehran will develop. It seems clear that neither the United States nor Iran wants a full-scale military conflict. The United States, or at least the current administration, wants to reduce its footprint in the region, and Iran is so weak it would lose the war. If rational actors prevail, there seems very little chance of the kind of military conflict that would disrupt production and exports of oil from the Gulf.

The risk comes from the chance that rational actors will not prevail. The United States has stumbled into military conflicts in the region recently. As for Iran, it is not clear how much control Tehran exerts over its regional proxies, most of which were creatures of the slain Soleimani. As U.S. sanctions tighten the noose on Iran’s economy, the government may become desperate. Moreover, it’s clear the two countries’ medium-term objectives are fundamentally incompatible.

It seems clear that neither the U.S. nor Iran wants a full-scale military conflict.

Iran wants a nuclear weapon, and its clerics want to stay in power. The United States wants a nuclear-free Gulf and a different government in Tehran. Tension is inevitable, and it may not always be possible to manage it.

There’s every reason to expect bursts of oil market volatility even if military conflict is avoided. But short of significant disruptions to Gulf oil exports, which we think is very unlikely, this will be happening against a backdrop of oil prices that are trending a bit lower over the course of 2020.

“Wag the dog” theories and Trump

The second risk to global growth revolves around decision-making and goal-setting in the Trump administration. Trump’s approach to policy issues is idiosyncratic. The decision to assassinate Soleimani is entirely consistent with what we have learned about his approach in the first three years of his Presidency. This is relevant for the future of the trade war and for Trump’s chances for re-election.

For the trade war, the question is what to make of the phase-one deal signed by China and the United States on January 15. Is the key message that a deal can be struck, and so a more comprehensive phase-two deal can be expected later in the year? Or is the message that Trump and his advisers have simply misjudged their negotiating partner and have gained little at considerable cost? The hasty manner in which the deal was announced, the contradictory leaks, the fuzzy math of Chinese agricultural purchases, and the vague promises about markets opening all suggest the deal is underwhelming.

Trade uncertainty remains high, in spite of the phase-one deal.

Trade uncertainty remains high, in spite of the phase-one deal. We expect a few months of calm before China trade issues return to the front burner of the election campaign. It’s too potent an electoral issue for Trump’s base for him to ignore it. For the re-election campaign, the issue is not really the “wag the dog” theories that seem to be beloved by some Democrats. Rather, the buildup to and the execution of the attack in Baghdad and the justification of it afterward illustrate the strategy behind Trump’s reelection campaign. He will make no effort to appeal to undecided voters; his strategy is designed to bolster his base.

The killing of Soleimani doesn’t affect Trump’s re-election chances, in our view. We won’t have a clear view on this until we know who his opponent will be and can assess how successful the second plank of Trump’s reelection strategy — to suppress Democrat turnout by denigrating his opponent — will be. But this confirms his electoral strategy. This matters for the economy because it’s a risky strategy for a President with consistently low approval ratings. It also raises the likelihood of a major change in economic policy after the election.

Next: Growing pains

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We believe the global economy will continue to bounce around the current growth pace. Trade, manufacturing, and oil, along with geopolitical risks, will play a role in determining the trajectory.