Explaining the Israel and Iran Missile Exchange

Oil markets have largely discounted the Iranian missile and drone barrage directed at Israel because it was essentially a ruse designed not to inflict any damage, but to save face at home and abroad. Almost all of the missiles were intercepted by Israeli defense systems, yet Tehran was able to boast of its first direct attack on Israel. 

What should be more worrisome for oil markets is Israel's response to Iran's response (to Israel's response), which came around midnight on Thursday, when first reports of an explosion inside Iran broke. The explosion took place in Iran's Isfahan province, which houses its nuclear facilities, as well as a key Iranian military air base. Reports from the ground suggest no nuclear facilities have been damaged, and Iranian state TV is claiming zero damage. Military sources have told various media that the Israel strike was limited and that the U.S. had been informed in advance. After nose-diving this week, initial news of the explosions sent oil prices up nearly 3% late on Thursday. 

Oil prices then fell back again as an Iranian source claimed there had been no attack - suggesting Iran was keen to downplay the event.

This is a cat-and-mouse game. 

Iran's "direct attack" on Israel was purposefully a failure, designed to complement Israel's defense systems. Any other outcome would have been disastrous for Iran. 

What Tehran is now most concerned about is an Israeli strike on its nuclear facilities, and what the domestic blowback would be if Iran proves incapable of protecting its only real regional and global leverage-the future ability to host a nuclear weapons program. It's as much about the potential for regime change as it is for the loss of regional power. 

Tehran is now busy trying to come up with a threat that could prove as a deterrence for such an attack. On Thursday, Iran's Islamic Revolutionary Guards Corp nuclear security commander warned that Iran would change its nuclear doctrine if Israel attacked its nuclear facilities. Iran's nuclear policy, as presented publicly (to which the IRGC security commander is referring), has been against the development of nuclear weapons. A warning of a policy change, then, is a warning that Iran will fast-track nuclear weapons development. In other words, Tehran is hoping to deter an Israeli strike on its nuclear facilities by generating significant concern in the West that an Israeli attack will lead to the creation of another nuclear-armed enemy.  

Will Israel attack Iran's nuclear facilities? The International Atomic Energy Agency (IAEA) thinks so. On Tuesday, three days after Iran's missile strike on Israel, the agency evacuated its inspectors from Iranian nuclear facilities because it was the most likely target.

Whether Israel will escalate further or if this was simply a test of Iran's defense system, just as Iran appeared to test Israel's Iron Dome, remains to be seen.