The S&P/ASX200 tumbled 114.5 points on Thursday, down 1.31 per cent, to 8,629, wiping all but 30 points of previous two sessions' gains.
The broader All Ordinaries lost 125.4 points, or 1.4 per cent to 8,851.4, wiping about $42.6 billion from its combined $3.05 trillion market value.
Crude prices surged more than six per cent during the session, an International Energy Agency plan to release millions of barrels of oil falling flat after Iran reportedly struck two oil tankers in the Straight of Hormuz.
"The IEA has just ordered the release of 400 million barrels of oil, its largest release on record, as the crisis in the Middle East reaches a tipping point," Stake senior market analyst Kylie Purcell said.
"Strategic reserve releases can help stabilise prices over the short-term, though futures will ultimately reflect whether supply through the Middle East returns to normal."
Only the energy sector ended the session higher, as banks and miners sold off.
Woodside shares jumped more than two per cent to $31.05, while Santos made gains and coal miners Yancoal and Whitehaven soared to beat out the top-200.
The moves came as Energy Minister Chris Bowen announced plans to cut fuel quality standards to allow higher sulphur levels for the next 60 days, hopefully circulating an extra 100 million litres of fuel per month.
BHP led the mining sector lower, the iron ore giant tumbling 1.9 per cent, while other industrial metals producers dipped as investors weighed the energy shock's impact on global growth outlooks.
Gold stocks also tumbled, as the precious metal eased to $US5,153 ($A7,230) an ounce, fading as investors sought safe haven in the US dollar.
Ora Banda bucked the trend to push higher after an encouraging drilling result, but handed back a significant chunk of the gains by the close.
Lynas Rare Earths was also exception as it rallied for a second day after locking in a price floor for a 12-year supply contract extension with a Japanese buyer.
The heavyweight financials sector dived 1.5 per cent as all big four banks traded lower, while insurance providers IAG and Suncorp edged higher in an otherwise sector-wide sell-down.
Interest rate-sensitive segments, particularly IT and real estate stocks, were hammered as a swathe of economists and analysts braced for a potential rate hike from the Reserve Bank next week.
While the RBA board ordinarily would look through the direct inflationary impacts of an oil shock, it would be mindful of higher inflation expectations becoming entrenched, Ebury market analyst Anthony Malouf said.
"Overall, this oil price shock arrives at an awkward time for the RBA, given it was already forecasting inflation to remain outside its target band until mid-2027," he said.
Ebury expects the RBA to keep rates on hold at next week's meeting, as it waits for key data to determine the road ahead for borrowing costs.
The Australian dollar is buying 71.22 US cents, down from 71.74 US cents on Wednesday at 5pm, as the greenback lifted on safe haven inflows.
ON THE ASX:
* The S&P/ASX200 fell 114.5 points, or 1.31 per cent, to 8,629
* The broader All Ordinaries lost 125.4 points, or 1.4 per cent, to 8,851.4
CURRENCY SNAPSHOT:
One Australian dollar trades for:
* 71.22 US cents, from 71.74 US cents at 5pm AEDT on Wednesday
* 113.32 Japanese yen, from 113.46 Japanese yen
* 61.72 euro cents, from 61.66 euro cents
* 53.28 British pence, from 53.34 British pence
* 120.78 NZ cents, from 120.69 NZ cents
15°C