Investment Strategy Insights: Schrodinger’s Strait: Toward a Partial Reopening

Hani Redha, CAIA - Global Multi-Asset, Portfolio Manager

The situation in the Middle East deteriorated further than many expected following the June Memorandum of Understanding (MOU). However, the recent escalation should not be mistaken for a complete breakdown in diplomacy. Instead, developments increasingly resemble a low-intensity phase of conflict in which both sides are attempting to re-establish leverage before returning to negotiations. Strike intensity has moderated from previous peaks, there has been no significant military build-up beyond that which predated the recent uptick in hostilities, and communication channels appear to remain open behind the scenes.

The Strait of Hormuz remains at the center of the dispute. The fundamental disagreement is not about military victory but rather about control and interpretation of transit rights. The U.S. continues to view the Strait as open to all shipping, while Iran maintains a different interpretation regarding authority over traffic moving through its waters. The resulting ambiguity was a key driver of the recent attacks on commercial ships and remains the primary obstacle to a durable solution.

Importantly, neither side appears capable of achieving its objectives through military means alone. The U.S. cannot realistically keep the Strait permanently open at an acceptable economic and military cost, while Iran cannot force a broader U.S. withdrawal from the region. Equally important for markets, neither side appears willing to escalate toward a high-intensity conflict that directly targets major energy infrastructure. This significantly reduces the probability of worst-case outcomes, even as uncertainty remains elevated.

We still believe that a negotiated outcome is the most likely path forward. The challenge lies in constructing a framework acceptable to all parties. The existing MOU proved too vague and left room for conflicting interpretations. The most probable end state is some form of multilateral transit arrangement involving Oman and Iran, ensuring that neither country exercises unilateral control over one of the world's most important energy corridors. At the time of writing, a potential deal seems close to completion, cementing Iran’s control over the Strait with Omani involvement. We shall see if such an arrangement is finalized.

For markets, the key issue is not the legal structure of any eventual agreement but the timeline for reaching it and the degree to which traffic through the Strait resumes. Several temporary buffers have supported energy markets thus far, most notably weak Chinese demand, fuel-switching and ongoing draws from strategic reserves. Yet, those buffers are not unlimited. China’s strategic petroleum reserve drawdowns have been particularly important in absorbing the shock. If current conditions persist for several more months, however, China may need to return to the global market more aggressively, creating additional upward pressure on oil prices. In that scenario, the market may prove considerably less resilient than it has been to date.

The more immediate stress point may not be crude oil itself but refined products and liquefied natural gas (LNG). Refinery utilization remains well below pre-conflict levels, crack spreads remain elevated and Qatar has continued to extend force majeure declarations on LNG exports. These conditions suggest that downstream energy markets remain tighter than headline oil prices imply. The longer disruptions persist, the greater the risk that shortages in refined products rather than crude become the primary transmission channel to the broader economy. A realistic scenario is a partial reopening which Iran modulates to maintain pressure on the U.S. during the next round of negotiations. In this scenario, energy prices will remain elevated without spiking uncontrollably.

Russia adds another layer of complexity. As one of the world's largest oil producers, Russian supply remains important to global energy balances. Higher oil prices have improved Russian fiscal dynamics, while Ukraine's continued targeting of refinery infrastructure has created localized shortages in products such as diesel and jet fuel. Although these disruptions are not yet economically severe, they reinforce existing stresses in refined product markets and further complicate the energy outlook.

The macro implications increasingly center on inflation and monetary policy. Persistent energy prices reduce disinflationary pressure at a time when central banks remain focused on inflation credibility. If the situation remains unresolved, elevated energy prices could tilt the inflation-growth balance in a more hawkish direction—market participants are increasingly contemplating a longer-than-expected tightening cycle, with multiple rate hikes from the Federal Reserve if inflation remains elevated. Whether it is appropriate to use monetary policy to respond to a supply-side shock is debatable, but the reaction function of policymakers appears relatively clear.

All told, the current environment appears more consistent with a prolonged economic headwind than with a geopolitical crisis spiraling out of control. The probability of all-out war or a broad attack on energy infrastructure remains low, yet the timeline for resolution in the form of a fully reopened Strait is likely longer than markets anticipated. As a result, the most relevant risk for investors in the coming quarters may not be escalation, but rather the cumulative impact of sustained energy pressures on inflation, monetary policy and global growth.

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