Is the Economic Threat From Iran Overhyped?

As if weary U.S. investors needed a new global headache, Iran has re-emerged as a potentially frightening wild card to the world economy by daring to even float the possibility of shutting down the crucial Strait of Hormuz.

A substantial disruption to the supply of crude oil through this pivotal naval passageway in the Persian Gulf would wreak havoc on energy markets, threaten the tepid U.S. recovery and almost certainly provoke a powerful military response.

But while Iranian jitters have already helped cause crude to jump to seven-month highs, the short-term risk of a closure of the Strait of Hormuz or a broader conflict with Iran is believed to be small.

“I think it’s unlikely because Iran doesn’t want a full-scale war with the United States or Israel,” said Matthew Kroenig, a professor at Georgetown University and a former Defense Department strategist. “In the short term, I don’t think there’s much reason to worry.”

Still, the mere threat of an incident is driving energy prices higher and creating a new risk for investors still hurting from a number of global events such as Europe's sovereign debt crisis and the earthquake in Japan.

That's because if Iran did shut down the Strait of Hormuz, crude prices would spike, perhaps beyond $175 a barrel. Depending on how long a disruption lasted and how high gasoline prices went, the broader economy would be hurt as consumer and business confidence would also decline.

Iran “is a bit of a wild card and things could get nastier as the year progresses,” said Josh Feinman, global chief economist at Deutsche Bank’s (NYSE:DB) DB Advisors.

A conflict with Iran would likely occur following one of three scenarios: a unilateral attack by Israel, a preemptive attack by the U.S. or Iran closing the Strait of Hormuz, where 17 million barrels of crude oil (35% of the world’s seaborne oil shipments) pass through each day.

The first two scenarios are unlikely in the near-term and would be telegraphed by the emergence of new evidence Iran is actually developing nuclear weapons.

In the third scenario, shutting down the free-flow of traffic through the Strait of Hormuz, which is 21 miles wide at its narrowest, isn’t exactly like flipping a switch. It would entail laying mines in the Persian Gulf, harassing oil tankers and using anti-ship missiles to attack U.S. Navy vessels and other ships.

In other words, it means starting a war with the world’s only superpower.

“I don’t think there is a lot of danger of the strait actually being closed,” said Schehrazade Rehman, a professor at George Washington University. “The main reason is because yes, it’s going to hurt everybody else who is trading oil through that strait, but the country that would be most hurt is Iran itself.”

'Shot Across the Bow'

Others believe Iran could lash out at its enemies due to new financial sanctions that have pushed the country into an economic box.

“2012 is going to be the year of reckoning with Iran, one way or the other. I think in the next six weeks you could see things come to a head,” KT McFarland, a former national security advisor and FOX News security analyst, told FOX Business.

Due to the new sanctions, “the Iranian economy is starting to go into freefall because they have no ability to then sell their oil,” McFarland said.

By threatening to close the Strait of Hormuz, “the Iranians have basically done a shot across the bow at Obama. They want to tell him…‘We can do this any time we feel like it. In fact, we could do it just before the election, so don’t mess with us.’”

Perhaps cognizant of the impact of the saber-rattling, the Pentagon said this week, "No one in this government seeks confrontation over the Strait of Hormuz. It is important to lower the temperature."

Closure Could Backfire

Kroenig is doubtful Iran would be able to successfully block the strait for longer than a few weeks before the U.S. would have it reopened.

“Iran’s military is just no match for the U.S. Navy,” said Kroenig.

Even if it had the capacity to hurt supplies, the resulting explosion in prices could actually backfire on Iran, which relies on oil as its chief export, shipping about 2.6 million barrels of oil a day last year.

As 2008’s price explosion demonstrated, at a certain point high prices causes demand destruction.

“The more annoying they can be and the more threatening they can be, the higher they drive investment money into oil and the higher they drive their revenue,” said Tom Kloza, chief oil analyst at the Oil Price Information Service. “But there’s a point where cheering the market would get cooked very, very quickly.”

Likewise, plunging consumer sentiment and business confidence would drive down overall economic activity -- a negative for the energy markets.

At the same time, unreasonably higher oil prices would make alternatives such as electric cars and solar power more economical, further impairing demand.

From a diplomatic standpoint, further provocation by Iran would likely alienate the country’s leaders from the few sympathetic nations it has left like Russia and China, which relies on Iranian oil imports.

Historical Parallels 

Of course, those who argue shutting the strait is against Iran's interests may mistakenly be assuming that the drivers of the Iranian bus are sensible and reasonable people.

Many analysts similarly believed Saddam Hussein would realize an escalation with the U.S. in 1990 was a losing proposition.

“When I was asked about [Iraq] beforehand I assumed there was some sanity there, but I assumed incorrectly,” said Kloza.

Due to Iraq’s invasion of Kuwait, the price of crude oil more than doubled from $21 at the end of July to skyrocket as high as $46 in mid-October, weighing on the U.S. economy.

However, Rehman said some of the wild card aspect of Iran's foreign policy has been removed by the deep unrest in the Iranian middle class and the memory of the Arab Spring.

“Absolutely, they can be unpredictable. There is no question. What makes this situation more predictable is they have elections coming up in March," said Rehman.

Still, history has shown that rising tensions between two adversaries can lead to an accidental escalation that results in all-out violence.

“There’s always the danger of miscalculation leading to some kind of conflict that nobody would want beforehand,” said Kroenig.