Oil spike: a surmountable challenge?

The escalation of violence in the Middle East is reverberating on Wall Street and Main Street – although many analysts still expect the US economy to grow this year.

Last week, the stock market lost 351 points, or 3.2 percent, and the Dow Jones Industrial Average edged closer to being negative for the year. The price of oil rose to a noninflation-adjusted record level of $76.95 per barrel, up almost $3 a barrel for the week.

The higher crude oil prices will probably mean higher prices at the pump – possibly as much as 20 to 25 cents a gallon.

The politics of the region are so incendiary that energy analysts are not sure how high oil prices will rise. Is $80-a-barrel oil the next stop, or could it race to $90?

"The whole area is a seething caldron of potential explosions," says Richard McCormack, a former undersecretary of State for economic affairs, now a senior adviser at the Center for Strategic and International Studies in Washington. "Seventy-dollar-a-barrel oil could look cheap."

Despite the uncertainty, many economists say it's too early to predict a slide into recession. Most are sticking to an expectation that US economic growth will slow to an annualized rate of 2-1/2 percent, a tepid pace that should ease the Federal Reserve's concerns about inflation.

"It will take more than higher gasoline prices to push us into a recession," says David Wyss, chief economist at Standard & Poor's in New York. "It's amazing how little impact the rising prices have had."

Nevertheless, as the tensions in the Middle East rise, Wall Street is full of scenarios – few of them positive.

"There is now an additional risk factor: The war could widen, or Iran could use oil as a lever over the West," says Robert Hormats, vice chairman of Goldman Sachs International in New York.

If Israel expands its bombing to include Syria, "it opens up a whole different set of dimensions" such as the involvement of Iran, Mr. Hormats says. The Iranians have said they will take action if Syria is attacked, he says. "You could see an attack on a ship or oil facility in the region. It's a very vulnerable part of the world's infrastructure."

If Iran were to pull out of the oil market, Standard & Poor's estimates that oil could jump to $90 a barrel, says Mr. Wyss. If Iran tries to close the Strait of Hormuz, he says, "you are talking $150 a barrel."

The last time uncertainty surrounded Iranian oil was after US Embassy employees were taken prisoner in Tehran in 1979. Oil prices started climbing sharply, and supply disruptions occurred. By 1981, according to the Energy Information Administration, which is part of the US Department of Energy, the price of oil peaked at $99.83, in May 2006 dollars.

However, back in 1981, energy was a much larger part of the US economy, representing 14 percent of the gross domestic product, Wyss says. Because energy was so crucial back then, the Federal Reserve pushed interest rates sharply higher to curtail inflation.

Today, energy represents 7 percent of GDP. "The Fed will not have to jerk interest rates up," says Wyss. "We are in better shape."

The nation also has 1 billion barrels of oil stockpiled in the Strategic Petroleum Reserve. By some estimates, this would provide the country with about 18 months of oil supplies.

If not for the geopolitical issues, the fundamentals of supply and demand in the global oil market don't support higher prices, says Mark Routt, an energy analyst at Energy Security Analysis Inc. in Wakefield, Mass. For example, ESAI analysis suggests that Saudi Arabia is continuing to pump oil but is putting it in storage because users don't need it.

"We think the price range is $10- to $15-a-barrel higher than the fundamentals would suggest," says Mr. Routt.

He doubts that Iran would try to affect oil supplies, since the country is a net importer of gasoline. In addition, he says, "Iran desperately depends on oil exports for its own internal expenditures."

As for stock prices, they have been weak since the beginning of April. Some of the softness is related to the expectation that earnings will fall later this year, when the economy is likely to slow. More signs of such a slowdown popped up last week: The Commerce Department reported that retail sales dropped in June, and a consumer survey by the University of Michigan found increasing pessimism.

This week, Fed chairman Ben Bernanke will appear before Congress for his semiannual testimony on the state of the economy.

"There are enough characteristics [in the economy] to suggest the Fed will pause" in raising interest rates, says David Kotok, chairman of Cumberland Advisors in Vineland, N.J. "Whether they do or not, we are much closer" to such a pause.

This week, investors also will get a look at Mr. Bernanke's archenemy – inflation – when the government reports the consumer price index. Wall Street is expecting it will rise at a 2.6 percent year-over-year rate. That is still above Bernanke's target.