Geography, Geopolitics, and Gamesmanship Leave Little Room for Error in Energy Markets

The path of hostilities in the Persian Gulf remains first on the list of concerns. After a brief, constrained reopening of the Strait of Hormuz following the ceasefire, shipping through the strait is again at a near standstill. Without shipping, production is effectively limited to what can be consumed locally or piped across Saudi Arabia to the Red Sea or across the United Arab Emirates into the Gulf of Oman.

The U.S. maintains a blockade on Iranian exports, while Iran is asserting control of the strait as the new status quo – whether for economic rent or strategic defense. Cumulative oil supply losses to date exceed a billion barrels, now the largest net loss of energy supply in history. With dozens of ships attacked, insurance costs have surged and the pool of owners willing to risk crews and hulls in the strait has shrunk. The situation is fluid, but supply from a region that provides nearly 20% of global oil must eventually normalize, or the global economy will have to adjust. (All data are from the International Energy Agency (IEA) with PIMCO calculations.)

Saudi Arabia’s rerouting of 4 million to 5 million barrels per day to the Red Sea in response to the Strait of Hormuz closures (according to Kpler) has been a critical lifeline for the oil market. Thus, the Houthis’ renewed attacks on Saudi shipping and infrastructure in the Red Sea escalate the risk that Saudi oil supplies can’t make their way out of the Middle East.

History shows the Houthis can meaningfully disrupt traffic through the Red Sea’s Bab el-Mandeb Strait to the south, with less impact on northern flows through the Suez Canal to the Mediterranean. If the issue is largely confined to Saudi vessels through this strait, while other ships pass, the impact is more logistical than fundamental. Asia’s dependence on Saudi barrels moving through Bab el-Mandeb could be reduced by rerouting ships north. That is taxing, but not a net supply loss.

The calculus changes considerably if the Houthis continue to strike Saudi export infrastructure, prevent ships from docking, meaningfully block all traffic through Bab el-Mandeb, or hit the pipelines running from the eastern producing basins to the Red Sea. The situation remains tenuous.

The third critical geography is the escalating Ukrainian campaign against Russian shipping, refining, and now export ports. The reach and efficacy of these strikes deep into Russia have been significant, and the costs to the oil market are adding up. Russian refining has been impaired for months, dropping processing to its lowest level in over 20 years, according to the IEA. Russia, normally a major exporter of refined products – particularly diesel – has not only cut exports but also been seen buying gasoline cargoes to replace lost domestic supply. Combined with reduced product exports from the Middle East, this has driven diesel, jet fuel, and gasoline to record premiums over crude.

More recently, Ukraine has stepped up attacks in the Sea of Azov and Black Sea, disrupting both energy and critical grain flows. Strikes on the Port of Novorossiysk, where several ships were hit by unmanned surface vessels (USVs), have curtailed exports of critical Kazakh oil. The port had been loading roughly 2% of global supply before the attacks (according to the IEA), which would be a non-trivial loss even in the best of times.

The problem facing the global economy is not limited to crude oil. Refined products – petrol, diesel, and jet fuel – sit at record price premiums to crude, reflecting genuine supply chain constraints. Even with crude nearly 30% off its year-to-date peak, refined products as of this writing are within a few percentage points of year-to-date highs, pushing U.S. retail gasoline above $4/gallon and diesel above $5/gallon (according to Bloomberg and the American Automobile Association).

Higher prices for refined products can significantly damage activity, because roughly two-thirds of world oil output goes to transportation, and Middle Eastern crude is refined disproportionately into the middle distillates (diesel, jet fuel, shipping fuel) on which Asia, Africa, and industry depend. Shortages translate quickly into reduced deliveries, stranded cargoes, and broader supply chain and food price pressures via diesel and fertilizer.

The Persian Gulf is also a critical supplier of liquefied natural gas (LNG), and global gas prices as of this writing have climbed to their highest since Russia’s invasion of Ukraine – a particular problem because, outside the U.S., inventories are on track to enter winter with the thinnest storage coverage in over a decade.

Crucially, many of the shock absorbers that cushioned the early stages of the U.S.–Iran conflict are now depleted. Strategic petroleum reserves globally have already released some 300 million barrels – offsetting almost a third of the global supply loss – dropping U.S. reserves to their lowest since 1983, when stocks of the Organization for Economic Co-operation and Development were being deliberately built after the oil price shocks of the 1970s (data according to the IEA). Commercial inventories have also drawn down, taking stocks of key refined products to multi-decade lows.

System flexibility is far lower today than earlier in the year, and, unlike then, we are heading into harvest, pre-holiday stockpiling, and the tail of the summer travel season. The room for error is minute.

One major surprise has been how far and fast China cut crude imports. The world’s largest importer nearly halved purchases through a mix of demand reduction, inventory withdrawals, and lower product exports – the last of which only worsened the global product shortage. Drawing on inventories built up in prior years, China has bought itself flexibility, but the open question is how long it will keep imports constrained. Never has a demand source of this scale adjusted by this magnitude.

The timing and pace of the demand recovery and ultimate restocking complicate views on second half of 2026 and 2027 balances. Should China maintain its current import levels, crude oil prices will likely face less upward pressure. Should China re-enter the market and begin restocking, oil supplies would need to ramp up to match, or shortages will emerge outside of China.

This is, at its core, a stagflationary supply shock: It lifts headline inflation broadly, while weighing on activity. Higher real energy prices act as a tax on consumers of oil and energy products, while a large global disruption in oil supplies would necessitate lower demand. How smoothly that adjustment happens is a key question for markets. As we learned during the pandemic, seemingly small disruptions can reverberate through global supply chains.

Regionally, the growth hit falls hardest on net energy importers – Europe, the U.K., Japan, and much of Asia. What is unique to this episode is how the AI-driven surge in demand for energy and for energy-intensive products (memory and chips) could compound the market disruption.

Monetary and fiscal tools have limited ability to offset a sustained energy shock; central banks are constrained by inflation and the need to keep expectations anchored, while government policies – including price caps and similar demand supports – can be counterproductive, since in a genuine shortfall prices must rise enough to clear the market, and blunting that mechanism in one region only pushes the global price higher.

Thus far, financial conditions haven’t tightened very much, as higher rates have been cushioned by a lower equity risk premium. But this is precisely why markets remain vulnerable to a sharp, nonlinear tightening if pricing shifts toward a more prolonged disruption.

Earlier in our careers, oil supply balances swinging perhaps a few hundred thousand barrels a day were enough to move prices and shape conclusions. Today, the number of line items carrying several-million-barrel uncertainty is surreal, with meaningful – and heavily upside-skewed – price implications if supply does not normalize.

It is precisely these pricing pressures that many are counting on to push the U.S. toward a resolution of the Iran conflict. However, given the lack of trust and the competing, often non-intersecting interests of the parties, a solution is hard to bank on.

For investors, hedging commodity risk through a commodity index may make sense. Commodity indices can help diversify portfolio risk and potentially enhance returns. And given the attractive carry on commodity indices today – e.g., 6% on the Bloomberg Commodity Index as of 23 July 2026 – the hurdle investors must clear to consider holding that exposure is meaningfully lower.

For more insights into commodity markets, listen to PIMCO’s Accrued Interest podcast discussion with Greg Sharenow on Apple and Spotify.