How Higher Oil Prices Will Hit Your Wallet

Prices for gas and other products will tick up, but the real trouble comes when oil hits $120 or so.

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At the end of 2010—when oil prices were around $90 per barrel—few of the economists making forecasts for 2011 predicted that unrest in the Middle East would send oil prices skyrocketing. Yet so far in 2011, turmoil in the Middle East has been the economic story of the year.

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The uprising in Libya is the first to directly affect the oil supply, with production in the African nation—which supplies about 2 percent of the world's petroleum—cut by an estimated 50 percent or so. The erupting civil war there suggests production could fall further. Bigger producers like Saudi Arabia and Iran aren't quaking yet, but the oil markets are suddenly more vulnerable than most forecasters guessed just a few months ago.

So far, global investors have taken it in stride. Prices for West Texas Intermediate, a common oil benchmark, are now close to $100, yet other positive trends have outweighed worries about an oil shock. Saudi Arabia has suggested it will pump enough additional oil to make up for wells that go offline in Libya or elsewhere. The S&P 500 stock index has risen a bullish 5.5 percent so far in 2011.

Yet higher oil prices will raise the cost of gasoline and other products in the United States, diluting the effect of the tax cuts that cheered Main Street and Wall Street alike when they were passed at the end of 2010. Higher energy costs could make some companies more reluctant to hire, delaying the desperately needed jobs recovery. A key threshold for oil prices seems to be $120 or so—the point at which the negative effects of rising energy costs become concentrated and hard to offset. If there are further surprises in the Middle East or speculators start to bid up prices—as they did in 2008—an oil spike could start to threaten the tentative economic recovery.

[See how Arab unrest could hard the world economy.]

Every $10 increase in the price of oil adds about 25 cents to a gallon of gasoline. That pattern has more or less held so far this year, with oil prices up nearly $10 per barrel and pump prices up by 30 cents or so, to $3.35 per gallon. If oil rose to $110, that would push gas prices to about $3.60; $120 oil would yield $3.85 gas, and so on. Hitting the crucial $4-per-gallon threshold could have an exaggerated effect on consumer confidence and economic growth, beyond the actual effect on people's budgets. "At that point," says forecasting firm IHS Global Insight, "the damage to growth would start shifting from an irritant to something worse."

IHS says that every $10 rise in the price of oil adds $30 billion to American consumers' gasoline bill, and costlier energy also drives up the price of food and other goods that require a lot of energy to produce. Higher bills related to energy mean people will spend less on other things. At current prices, most consumers can adjust. But IHS says if oil hits $120 per barrel, that could cut GDP growth by 0.7 percentage points, which would be a significant drag on an economy that's growing by less than 3 percent per year. It would be worse if $4 gas were to produce a bunker mentality that caused consumers to stop spending and hoard cash.

[See why $4 gas will cause less pain this time.]

Rising oil prices have a more subdued effect on businesses, and even benefit some of them—which is why the stock market sometimes reacts positively as the price of oil goes up. Analysis by Bank of America Merrill Lynch shows that higher prices for oil benefit a significant number of S&P 500 firms, especially companies that produce commodities and earn more revenue as the price of those commodities goes up. The most obvious beneficiaries are oil companies like Exxon Mobil, which alone accounts for about 3.5 percent of the S&P 500 stock index's overall weighting. The energy sector overall accounts for about 13 percent. And many other firms sell goods and services to those commodity producers, so they benefit as their customers flourish and buy more stuff.

Bank of America figures that overall, rising oil prices will help push stock values higher until oil hits that pivotal threshold of $120 per barrel. At that point, the negative effects of rising commodity prices—such as reduced demand for cars, clothes, food, and other consumer goods—would start to outweigh the effects from higher revenues at big firms. If Bank of America is right, that means ordinary investors don't need to worry about a modest rise in oil prices damaging their portfolios, unless something else makes it worse. It also suggests a buoyant stock market will continue to coax consumer confidence upward, offsetting a bit of the gloom that comes as gas prices creep up.

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Consumers have also managed to adjust to energy prices that have been rising by much more than overall inflation for the last several years. Investing firm Oppenheimer points out that oil prices averaged about $25 per barrel between 1980 and 2004, but have been closer to $75 per barrel, on average, since 2005. With the days of cheap energy apparently over, Americans have bought smaller, more efficient cars, and they're starting to downsize their homes and find other ways to cut back on energy use. "We think rising oil prices do not have the shock value they once possessed," analyst Brian Belski wrote in a recent note to clients. As evidence, he highlights consumer spending that is returning to normal levels, even though gas is about $1 per gallon higher than it was just a year ago.

The biggest risk to oil markets and the global economy probably isn't what happens in Libya or any other single country, but a combination of unforeseen events that produce compound troubles. If uprisings in the Middle East spread to huge oil producers like Saudi Arabia or Iran, that would obviously send prices surging. But a speculative bubble could be just as damaging. That might already be happening, since some economists think oil prices have risen by more than the fundamentals of supply and demand warrant—an echo of the head-scratching that occurred when oil hit nearly $145 per barrel in 2008. Inflation, rising interest rates, or a spiraling U.S. debt crisis could also intensify any woes caused by rising oil prices. Or, the next big problem could be something nobody's paying attention to right now.

Twitter: @rickjnewman