All eyes on the Strait of Hormuz

The United States and Iran are at loggerheads over a way forward to a peace negotiation. This past weekend, Iran responded to the United States proposal in a manner President Trump deemed “totally unacceptable” via social media.

The US proposal essentially boiled down to a simple two-point plan: fully open the Strait of Hormuz and fully and verifiably end the Iranian nuclear program. The Iranian counterproposal asked for war reparations by the United States, full Iranian sovereignty over the Strait of Hormuz, and the release of seized Iranian assets.

Meanwhile, over 1,500 merchant vessels and 20,000 mariners are trapped in the Persian Gulf. The fragile ceasefire is frequently tested by dueling Iranian drone attacks on the energy infrastructure of the Gulf Arabs and merchant shipping, and by US responses to Iranian aggression. Two blockades are in effect, one by Tehran of the strait itself and the other an overall blockade of Iran’s ports by the United States.

Where does the crisis head now? And what could be the longer-term investment implications of the outcome? Absent a sudden breakthrough in diplomacy, President Trump appears to have three options at this point.

First, he could simply withdraw US forces and essentially walk away from the entire situation by claiming the United States and Israel had achieved their military objectives in seriously degrading Iran’s offensive military capacity. In that scenario, he would say the Iranian nuclear material – almost a thousand pounds of near-weapons-grade uranium (enriched to 60%) – would remain in its probable location at the bottom of a destroyed complex in Isfahan and the United States would place it under continuous overwatch via satellites. The problem with that scenario for the global economy is obvious: Iran would continue to have control of the strait, essentially holding the world’s economy hostage and illegally extracting rents for passage. This is the least likely path forward, but midterms are coming, so it cannot be ruled out entirely.

A second option is a return to a full-on, highly destructive bombing campaign. In this case, the US military would focus on leadership targets alongside Israel, seeking to eliminate the intransigent elements of the Iranian Revolutionary Guard clique who appear to have the upper hand in Tehran. The Navy and Air Force strike aircraft would also place more attention on any Iranian military capability that provided it the means to keep the strait closed, e.g. mines, maritime drones, short-range ballistic missiles around the strait. In this option, the US might also consider striking Iranian oil and gas facilities, perhaps including Kharg Island. The problem here is the Iranian response, which most likely would be directed not only at merchant shipping all over the Gulf (to include a potential mass minelaying event in the strait) but also against Saudi and Emirati oil and gas facilities. This is unattractive to the United States because it is extremely expensive and continues to deplete US military stockpiles, and also because the war is highly unpopular in the USA.

Third and most likely, the United States will continue to attempt to constrict the Iranian economy with its blockade. This is a challenging task, even for the US Navy, because of the immense size of the Iranian southern coast, over 1,100 miles (far greater than California at 840 miles, for example). This may take months, if not years to accomplish, and the cost of maintaining a true blockade is very high in terms of length of deployments for US ships, now stretching well over the normal six-month term.

It is also a slow-moving option and not suited to the ticking clock of midterm elections given the cost of gasoline and the unpopularity of the conflict. We believe the US will continue to encourage allies to participate in opening the strait, and both France and the UK have indicated interest in doing so.

Barring a breakthrough in talks, we believe the President will probably keep the blockade in place for the moment and resume some level of military action – seeking to elicit a better offer from the Iranians. This option – maintain or increase pressure while still seeking a negotiated outcome – is our base case with a 60% likelihood. If successful, the strait might reopen in four to eight weeks. The other 40% of outcomes are a batch of unattractive events, including a months-long strait closure; increased Iranian attacks on Gulf oil infrastructure; Iranian terror attacks in Israel and even the United States; and increased use of cyber (perhaps with technical assistance from Russia).

None of this is comforting to investors, but in our view there are some clear opportunities that emerge from the geopolitical uncertainty.

The first is obvious, which is the impact on energy. We believe the global system will see some level of “rewiring” to include more pipelines and shipping routes that bypass the Strait of Hormuz. There will also likely be opportunities in renewable and sustainable energy technology, even in the era of “drill baby, drill.” The effort to bring more oil from other sources – for example, from Venezuela, the Arctic, and UAE now that they are out of OPEC – will likely increase.

A second major opportunity set will be in defense spending, which is rising rapidly in the United States, Europe, and Japan. A premium on new technologies – drones, lasers, artificial intelligence for war, hypersonic missiles, and special forces – is clearly emerging not only from the war in Iran but also from the four-year conflict in Ukraine.

Thirdly, given their geographic position somewhat out of the maelstrom of the Middle East and the geopolitical tensions between the west and Iran, we believe India emerges as an attractive investment opportunity. New Delhi seems keen to work with all sides in the current geopolitical environment, and alongside its strong demographics and status as the world’s largest democracy, exploring commercial opportunities there could make sense.