Soaring oil prices pummeled the market Friday. But the sell off was more about paranoia than real risk. Investors should know the drill by now.

A closely watched jobs report on Friday showed that employers did plenty of hiring in February, adding to the evidence that a strong economic recovery in the U.S. is gaining steam. But investors largely ignored the news: Instead, markets sold off again as oil prices soared amid escalating violence in Libya.

Part of the anxiety is understandable. Rising oil prices tend to slow overall economic growth while depleting consumers' purchasing power at the same time. Spiking oil prices played a major role in the excruciating stagflation of the 1970s, for example.

But as with many other economic topics, like inflation, investors are better off taking a measured look at what rising oil prices would really mean for the economy rather than just running scared. Despite all the paranoia, the actual impact may be less than skittish investors fear.

Slim Odds That Crisis Will Spread

The brief spell of jubilation that marked the success of pro-democracy demonstrators in Egypt stands in stark contrast to the bitter violence now spreading through Libya. And given Libya's position as a midsized oil producer, many on Wall Street are busy trying to figure out what a shutdown of its oil output would mean for the world economy.

"The collapse of the Mubarak government in Egypt two weeks ago has been quickly followed by a deteriorating situation in Libya, where Colonel Qaddaffi now appears to have lost control over much of the country, resulting in the first significant hit to oil production," JPMorgan Chase (JPM) analysts wrote in a note to clients this week. "Even more importantly, risks are real and growing the crisis will spread to other oil producing countries such as Bahrain and, in the worst case scenario, Saudi Arabia."

But the bank puts the odds of further contagion in the region at a paltry 5%. And it sees a more welcome scenario, one in which increased production and social measures push prices down to $95 per barrel, as a far more likely ending.

The Only Thing to Fear Is Fear Itself

Even steep rises, though, may not have as large of an impact on the world economy as many alarmists think.

JPMorgan calculates that a 10% surge in oil prices would cut the world's gross domestic product by just 0.25%. By that reckoning, oil prices that climb to $110 a barrel would translate into about a 19% increase in overall prices throughout the economy during the first quarter of 2011. That would raise inflation by 1.3% while chopping 0.65% from consumer spending, resulting in a 0.43% hit to overall GDP growth.

The bank also calculated how rising oil prices would affect corporate earnings, a key element of stock valuations. There, too, the projected impact was far more muted than many investors might think. According to JPMorgan, a 10% rise in oil prices would translate to only a 1% cut in earnings per share.

But while the real impact on global growth and corporate earnings might be muted, the impact on investor psychology remains a real risk for stocks. "A key support for risky assets so far has been benign inflation and strong growth; the Middle Eastern crisis has not introduced upside risks to near-term inflation as well as downside risks to growth," JPMorgan analysts wrote.

Fear itself, then, might be the most legitimate concern for stock market investors.


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