Iran must choose between revenge and survival in response to Israel. Markets say it’s choosing survival

Iran’s powerful proxy network across the Middle East is being dealt blow after blow from Israel, which has dramatically escalated fighting with Lebanese militia group Hezbollah and on Friday killed its long-time leader, Hassan Nasrallah in a series of airstrikes on Beirut.

Hezbollah is Iran’s most important strategic ally, operating as both a militant and political organization that Tehran has funded and nurtured since its inception in 1982 to become what is widely seen as the most heavily-armed non-state group in the world.

Beginning with a series of sabotage attacks earlier in September that led to the explosion of thousands of Hezbollah pagers, Israel has gone from disabling massive swathes of the group’s communications to taking out its most powerful leader, as well as several other senior commanders.

Iran’s generals and its supreme leader Ayatollah Ali Khamenei have pledged revenge, but their actions and language suggest a more measured response so far. An all-out war between Israel and Iran would be devastating to the entire region, but would be particularly damaging to Iran, whose economy is already in dire condition and whose oil facilities could be particularly vulnerable to attacks.

Notably, oil prices — which are typically highly sensitive to threats to supply — are still hovering near $70 a barrel for international benchmark Brent crude, suggesting markets also predict a conservative response from Iran, one of OPEC largest oil producers.

“⁠In the last two weeks, Israel’s decisive blows to Hezbollah have in essence gutted the crown jewel of Iran’s regional proxy network,” Behnam ben Taleblu, a senior fellow at the Foundation for Defense of Democracies, told CNBC.

“Iran’s response options aren’t good. If the Islamic Republic gets more directly involved there will be a direct target on its back. To that end, survival beats out revenge, especially in a war of attrition.”

Following the assassination of former Hamas leader Ismail Haniyeh in Tehran on July 31, Khamenei vowed a “blood for blood” response, which has so far yet to happen. But the tone following Nasrallah’s killing was markedly different — the Iranian leader made clear that it would be up to Hezbollah itself to choose its response.

“All the Resistance forces in the region stand with and support Hezbollah,” Khamenei said on the X social media platform on Saturday. “The Resistance forces will determine the fate of this region with the honorable Hezbollah leading the way.”

Iran’s economy has suffered from years of crippling western sanctions, as well as widespread mismanagement and corruption. Prolonged high inflation has eroded purchasing power for Iranians, making basic necessities difficult to afford mid severe depreciation of the Iranian rial. The country of nearly 90 million is in no position to afford a war, regional analysts say.

Iran’s recently-elected President Masoud Pezeshkian appeared determined to try to turn these tides, in part by expressing his desire to mend relations with the West and restart talks on the JCPOA — or the Iranian nuclear deal — which could theoretically ease sanctions on Tehran in exchange for curbs to its burgeoning nuclear program.

Often described as a reformist, Pezeshkian is reportedly urging restraint in response to Israel’s continuing strikes on Hezbollah and on Yemen’s Houthi militants, who are also supported by Tehran and have been targeting Israel and Israeli-linked vessels in the Red Sea.

“Despite rhetorical promises of retaliation, Iran has shown restraint in practice, even as Israel has escalated sharply,” said Sina Toossi, a senior nonresident fellow at the Center for International Policy. “Many reformist elements within the Pezeshkian administration argue that Iran cannot afford a war that risks its critical infrastructure being targeted.”

Still, more hardline elements of Iran’s government feel a powerful response is necessary to establish deterrence against Israel, fearing that Tehran or any of the country’s nuclear sites could be the next target.

For the time being, at least, Iran’s priority “appears to be maintaining its regional influence and continuing attrition warfare against Israel without triggering a broader confrontation that could destabilize its alliances in Lebanon, Iraq, Syria, and Yemen, or result in strikes against Iran itself,” Toossi said. 

On Monday, Israeli Defense Minister Yoav Gallant signaled a ground offensive into Lebanon could take place in the coming days. It remains to be seen whether such a development could change Iran’s calculus.

Hezbollah said it will appoint its new leader at the earliest opportunity, and that it continues to fire rockets as far as 150 kilometers (93 miles) into Israeli territory, adding that its fighters are ready for a potential Israeli ground incursion. Israel continued its airstrikes through the weekend, saying it hit multiple targets in Lebanon on Sunday.

“What we are doing is the bare minimum… We know that the battle may be long,” Hezbollah deputy chief Naim Qassem said Monday, according to Reuters. “We will win as we won in the liberation of 2006 in the face of the Israeli enemy,” he added, referring to the last bloody war between the two adversaries.

While Iran is on the back foot, it appears dedicated to maintaining support for its regional proxies.

“Iran is very unlikely to get in front of Hezbollah, but it is going to stand behind it and try to rehabilitate it,” Ali Vaez, Iran project director at non-profit Crisis Group, told CNBC.

“Iran’s regional deterrence is in shambles now. But that doesn’t mean that Iran is going to give in and give up. It simply has no viable strategic alternative to supporting nonstate actors who provide it with strategic depth.”

Israel, meanwhile, shows no sign of backing down, as it pushes ahead with its stream of tactical victories — although these have not yet translated into achieving Tehran’s strategic goals of forcing Hezbollah further from its northern border, so that it can return its displaced residents to their homes.

“We suspect that some oil market participants will look past this escalation given that there still has not been a major physical supply disruption and Iran has not demonstrated any appetite to enter this nearly year-long conflict,” Helima Croft, head of global commodity strategy and MENA research at RBC Capital Markets, wrote in a research note published Monday.

“And yet, it is extremely difficult to see where this regional conflict is headed, and whether this is the beginning of the end, or the end of the beginning.”