So far, equity markets have shrugged off the sinister threat that rising oil prices pose to the global economic recovery. But the deteriorating situation in Libya could force them to rethink their complacency.

Reports over the weekend of heavy gunfire in the Libyan capital of Tripoli fanned fears that the country is on the brink of a full-scale civil war. Forces loyal to the government of Muammar Gaddafi claimed to have launched a major counter-offensive and recaptured some of the eastern parts of the country from rebel forces. However, anti-government rebels disputed these claims, saying that they retained control of Benghazi, Libya’s second largest city, as well as other eastern towns such as Raw Lanuf, an oil exporting hub.

So far, the armed conflict in Libya has caused the country’s oil output to dwindle to about 600,000 barrels a day, from about 1.6 million barrels daily in January. And worries about oil supplies have pushed oil prices higher, with the price of Brent crude, the European benchmark for oil prices, finishing last week at $116 a barrel on Friday.

But some believe that oil prices will move significantly higher, particularly if the political upheaval currently spreading through the Middle East and North Africa engulfs other major oil producers, such as Yemen, Bahrain, Oman, Algeria and Nigeria.

At the same time, there are worries that higher oil prices will puncture the fragile US economic recovery by crimping the spending power of US consumers.

Already there are signs that US consumers are battling to keep pace with higher food and energy prices. In the past six months, an improvement in the US employment market has seen wage income rise by $US111 billion. At the same time, however, spending on food and energy has jumped by $US116 billion. In other words, the boost in income from the jobs growth has been more than given back in higher food and energy costs, leaving US consumers in an even more vulnerable position.

Even worse, long-term US interest rates are edging higher on worries that rising oil and commodity prices will push inflation higher. US home owners, already confronted with the dismal reality that the values of their homes again are tumbling, face the additional strain of higher mortgage rates.

This poses a further challenge for the US economy, particularly as the rates on large numbers of adjustable rate mortgages start being reset from next month on. Many US households are about to face the grim choice of meeting higher repayments on their mortgages — at the same time as they are already struggling with higher food and energy bills — or else defaulting on their mortgage payments. Faced with plunging home prices, and higher mortgage rates, an increasing number of US households may choose the second option, which will mean fresh troubles ahead for the US banking sector.

To date, investors have chosen to be cheered by signs that the US economy is gradually gaining strength. But this optimism remains vulnerable. The escalating conflict in Libya means that the oil price will remain high for the foreseeable future, inflicting a heavy punishment on the embattled US consumer.

*This first appeared at Business Spectator.

Peter Fray

Save up to 50% on a year of Crikey.

This extraordinary year is almost at an end. But we know that time waits for no one, and we won’t either. This is the time to get on board with Crikey.

For a limited time only, choose what you pay for a year of Crikey.

Save up to 50% or dig deeper so we can dig deeper.

See you in 2021.

Peter Fray
Editor-in-chief of Crikey

SAVE 50%