Libya Unrest and the Oil Markets

Energy prices have surged in recent days as a result of the political violence in Libya and fears that the unrest may continue to spread to other oil-producing countries. U.S. crude futures hit $100 a barrel for the first time in more than two years before retreating to close the week just above $98.

Reassurances that other countries will help make up any oil shortfall calmed the equity markets on Friday, but not enough to overcome meaningful weekly declines: The S&P 500 Index dropped 1.7% for the week, while European and Japanese markets slid 2.4% and 2.9% respectively.

The financial markets are reflecting the concern that a sustained and significant rise in oil prices could impede the U.S. and global economic recovery by stirring inflation and dampening spending.

The biggest risk to the economy from climbing energy prices stems from consumers. Pricier oil drives up the costs of everything from gasoline to the raw materials used to make nylon and food packaging. That could prompt consumers, who lately have shown more willingness to spend, to cut back their purchases.

A reduction in consumer spending reverberates through the economy by crimping businesses, making it less likely that employers will commit to the additional hiring needed to lower the 9% unemployment rate in the U.S.

Events as they have unfolded thus far do not compare with the major historical oil supply disruptions, and are unlikely to produce a large enough impact to precipitate a new economic downturn. Libya accounted for only 4.6% of the 29.4 million barrels of oil pumped daily by the Organization of Petroleum Exporting Countries in January, making it OPEC’s ninth-biggest producer, according to data compiled by Bloomberg. Further, U.S. government data show the economy imported less than half-of-1% of its oil imports from Libya in the past two years.

The question now is whether turmoil in the Middle East and Northern Africa could lead to a sustained cutback in oil production or delivery. It is too soon to tell how far the pro-democracy protests that have roiled Egypt, Bahrain and Libya will spread. For now, most analysts do not anticipate Iran and Saudi Arabia, repressive governments which also happen to be two of the world’s biggest oil producers, joining the revolution.

Because the recent rise in the price of oil is driven by something other than increased demand, it is unlikely to prompt the Federal Reserve to move more quickly toward raising short-term interest rates or otherwise moving to tighten credit. That could change if higher oil costs begin to drive extended increases in prices of other goods and services, but Fed policymakers continue to view the chances of inflation rising by more than their informal target of about 2% this year as remote.

While a sustained oil price of $100 a barrel would likely shave about two-tenths of a percentage point off economic growth, the Federal Reserve forecasted last week that the U.S. economy would grow by 3.4% to 3.9% in 2011, up from 2.9% last year. Many economists believe that the price of oil would have to rise to at least $120 a barrel, and stay there, to threaten the recovery.

Truepoint Wealth Counsel is a fee-only Registered Investment Adviser. Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & 2B filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice. The accuracy and completeness of information presented from third-party sources cannot be guaranteed.

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