Oil market update: The long road to normalization

The resumption of hostilities between the US and Iran in recent weeks has disrupted tanker traffic through the Strait of Hormuz once again and moved inflation risk back into focus. The scale of the conflict’s impact on the growth outlook will likely depend on how much energy prices rise and for how long, and how policymakers respond given their continuing accommodative stance on monetary and fiscal stimulus.

At the time of writing, markets still seem mostly priced for a relatively quick and lasting resolution to the conflict and the normalization of energy flows and prices. If that view turns out to be broadly right, the market is likely to reengage quickly with the strong, policy-driven growth outlook. However, we think the risk is increasingly skewed to a more sustained rise in energy prices, which could add to inflation pressures in the near term. For oil prices specifically, the risk premium is elevated as Brent crude crosses US$100 per barrel (bbl) with the possibility of this benchmark price rising further in the next few weeks.

Looking beyond the current conflict, it may take time for energy markets to normalize once the Strait is fully open again and traffic gradually increases. Estimates suggest it could take at least four months for production to recover to roughly 80% of pre-crisis levels following a reopening. But shifting supply and demand dynamics in the longer term should help prices return to levels that would ease inflationary pressures and spur global growth.

The risk premium for oil prices is reescalating.

After a partial recovery in tanker traffic during the brief ceasefire between the US and Iran, the situation in the Strait of Hormuz has reverted to severe disruption. Our tanker-tracking research puts implied flows through the Strait at roughly one-quarter of their pre-crisis level on a four-week basis, with the most recent weekly data deteriorating following the slight uptick in June.

Rerouted flows in Saudi Arabia through the east-west pipeline to the Red Sea are helping to offset some of this disruption, but even with these pipelines running close to capacity, net Gulf seaborne exports remain several million barrels per day below pre-war levels. Moreover, the potential for escalation by the Houthis in the Red Sea puts this critical offset at risk. These factors underscore the reality that the energy market and the global economy must reckon with: The Strait of Hormuz has no substitute.

Inventories tell a similar story from the other side. Commercial stocks sit roughly 6–7% below their five-year norm after one of the steepest quarterly draws in the modern era. However, the pressure on commercial inventories has eased in recent weeks, largely due to significant drawdowns in strategic petroleum reserves. Likewise, inventories of US products are up despite the recent draws. However, flattening is not the same as rebuilding. With buffers being thin, geopolitical risk can be priced asymmetrically, particularly amid an uptick in instability in the Russia/Ukraine conflict and direct attacks on and bans of Russian diesel exports.

From a market view, per-barrel Brent crude may trade in the US$90–US$100 range on the front end of the oil price curve over the next six weeks. We hold this view with moderate conviction recognizing how things can change in short order. If flows through the Strait recover decisively or a genuine deescalation takes hold, the geopolitical premium would deflate and we would expect Brent prices to slide back toward the mid-US$70 range. Equally, a prolonged closure or escalating conflict could push front-end prices above US$110/bbl, a level where markets have historically become far more sensitive to oil prices. We consider both scenarios as realistic alternatives to our near-term view, given the fluidity of events in the region.

Fair value oil prices are a long way below spot.

Strip out the geopolitical risk premium and our supply-and-demand analysis suggests that front-month Brent is fairly valued around US$70/bbl. That is not a forecast for oil prices in the medium term; it is the anchor we would expect the market to return to if the current disruption clears. The gap between that number and our tactical range is the widest it has been all year, which is precisely why we do not ascribe to a single forecast.

Our medium-term fair-value anchor reflects three observations:

• First, the feared demand destruction was largely a mirage of destocking; of the very large apparent demand loss at the peak of the crisis, we estimate only a small fraction was real as refineries were able to regain crude access.
• Second, Gulf production has recovered and storage backlogs have cleared faster than consensus expectations. Saudi and UAE production is expected to resume quickly, while countries like Iraq and Kuwait may take more time as their facilities may have suffered damage.
• Third — and this is the swing signal we watch weekly — China's crude imports are still falling, based on our review of customs data. Should these imports stabilize, it would be the first hard evidence that the physical market has found its footing.

In the long term, surpluses are getting bigger, not smaller.

Beyond the near-term disruption, the structural picture has shifted against the bullish case for higher oil prices. Our estimated 2027 balance has expanded from roughly half a million barrels per day of surplus earlier this year to over two million barrels per day at present.

Producer behavior is a key factor in our view beyond 2026. We are increasingly focused on the potential for a renewed price war within OPEC+; the UAE has invested in additional production capacity for many years and has clear incentives to monetize those investments, while Iraq has continued to push for higher production allowances and greater quota flexibility. If geopolitical tensions ease and spare capacity returns to the market, maintaining production discipline across OPEC+ could become increasingly difficult.

Another important question concerns the composition of non-OPEC supply growth. Expectations have become increasingly constructive for production growth from countries such as Canada, Brazil, and Guyana, but it remains unclear how much of that incremental growth will ultimately come in the form of natural gas liquids (NGLs) versus crude oil. To the extent that a larger share of future supply growth comes from NGLs, the implications for the crude oil market may be materially less bearish than headline growth figures would suggest, particularly given that refined product demand remains the primary driver of our oil demand outlook.

The implications for investors

Historically, the largest policy and market reactions to oil shocks occur several months after the initial disruption. We continue to view Q3 as the critical window, when inventory depletion, inflation pass-through and policy responses are most likely to converge.

So far, the reaction to the conflict from developed market central banks risks further de-anchoring inflation expectations. On the fiscal side, the conflict has caused further deterioration in countries’ debt trajectories through higher rates, but also the growing potential for meaningful stimulus as the crisis extends. Monetary policy was loose and fiscal policy was stimulative before the conflict, and both have been loosened further since. The rise in inflation expectations has pushed average real rates across developed markets into negative territory.

The takeaway for investors is that government and central bank policy credibility is becoming an increasingly important source of risk, but also a source of return potential, particularly in countries with the most challenging dynamics. Japan, the UK, France, and the US are key to watch in this regard. While we are some way from the magnitude of the oil shock we saw 50 years ago, the risk of those dynamics reoccurring would rise if this evolving conflict proves significantly more protracted than the market currently expects.