The markets are paying attention to the risk of further escalation

The Israeli government has announced a tough response to Iran's unprecedented rocket fire on Tel Aviv, keeping the Middle East on tenterhooks as fears grow of a possible all-out war between the two long-time enemies.

On Tuesday evening, Iran fired around 180 ballistic missiles at several sites across Israel. According to Tehran, the attack came in response to the Israeli assassination of Hezbollah chief Hassan Nasrallah the week before.

Israeli authorities said there were no casualties in the offensive and most attacks were intercepted. But the event marked a turning point in a series of escalating back-and-forths, as Tehran appeared determined to re-establish deterrence and prove to Israel that it could and would attack at a time of its choosing.

Markets are now prepared for a likely retaliatory move by Israel against Iran. Defense stocks are recovering – and long-subdued oil prices are also likely to rise as industry observers now see a real threat to crude oil supplies.

Up to 4% of global oil supplies are at risk as oil infrastructure in Iran – one of OPEC's biggest crude producers – could become a target for Israel.

Oil prices rose over 5% in the previous session after the missile attack before retreating to a 2.5% gain. The December delivery contract of global benchmark Brent was trading at $75.37 a barrel at 10:30 a.m. in London, while U.S. West Texas Intermediate futures for the previous month of November were up 2.68% at $71.70 per barrel increased.

“I think that focus could be on Israel, but the focus should really be on Iran and whether there will be attacks on regional infrastructure. “That's really the only event we're looking for that could determine a more dangerous path for equity markets, for risk assets in general,” Frederique Carrier, head of investment strategy for the British Isles and Asia at RBC Wealth Management, told Capital on Wednesday Connection from CNBC.

“When we look at war actions since the 1940s, we know that those that trigger an oil crisis (and) a sustained rise in oil prices have a lasting impact on stock markets.”

She added that there was “no evidence” of this so far.

Lewis Sage-Passant, associate professor of intelligence at Sciences Po in Paris, described energy markets as nervous as investors watch Israel's next moves.

“Iran relies on a handful of 'chokepoint' export terminals, such as Khark Island, which will be tempting targets for Israel,” Sage-Passant said. “Teams in the energy sector appear to be nervous about the increasing confrontation with attacks on regional infrastructure. Even without direct attacks, much of the world's oil infrastructure lies within the path of these missiles, so of course everyone is very nervous.”

After Tuesday's attack, U.S. national security adviser Jake Sullivan warned of serious consequences for Iran and said the U.S. would strongly support Israel. But Washington's efforts to de-escalate and prevent a regional conflict have clearly failed, according to Roger Zakheim, a former U.S. deputy defense secretary and director of the Ronald Reagan Institute in Washington.

The Iranian attack and the subsequent Israeli response “could have an impact on the oil and energy markets, especially aviation and, I think, certainly on the defense sector… investments in missile defense and munitions, the companies that produce these systems “We will be influenced by events in the Middle East,” he said.

In the immediate aftermath of the Iranian attacks, U.S. defense stocks hit record highs. Their European counterparts also assessed rising conflict risks higher on Wednesday morning, with Saab and BAE Systems rising 2.2%. Thales and Rheinmetall both rose more than 1.3%.

“The Israelis will respond now, not only in kind, but also doing whatever is necessary to restore deterrence,” Zakheim added.

The question remains whether a strong Israeli response would restore deterrence or trigger further escalation from Iran and plunge the nations into full-scale war. In a statement following the country's rocket volleys, Iran's Foreign Minister Abbas Araghchi said: “Our action is complete unless the Israeli regime decides to seek further retaliation.” In this scenario, our response will be stronger and more effective.”

Aside from geographical bottlenecks in the oil market, “there are numerous entities on (the) Iranian side and also (on) the Israeli side, all of which could be targeted in terms of critical infrastructure,” says Sara Vakhshouri, founder and president of SVB Energy, said CNBC's Capital Connection on Wednesday.

“This infrastructure is all connected,” she said, emphasizing that Iran’s sheer size makes it “impossible to somehow secure everything.”

Some market watchers are warning that oil prices could reach $100 a barrel.

Vakhshouri expressed doubts about such a forecast, pointing out that geopolitical events often only affect oil prices temporarily. The extent and duration of any impact on the market “depends on where the destruction would occur and how much oil is removed from the market,” she said.

“In any case, prices will show an upward trend. (But) the other thing is that the market is focused on a lot of uncertainty on both sides… (be it) the demand side or the geopolitical side.”

A longer-term issue underlying oil prices is the overall global demand situation. Brent crude hit a 33-month low in mid-September and was hovering around $70 a barrel until the Iranian missile attack on Israel, reflecting slowing global demand and ample supply, particularly from non-OPEC+ producers .

“So it’s a very interesting moment now,” Vakhshouri said. “Due to the fear of low demand in the market, we are keeping prices stable, but the geopolitical factor is also real. Either side could really drive the market and we have just seen prices go up and down in the last few days depending on what the sentiment in the market is triggered.”