Europe's Iranian oil trap

The fragile global economy has been dealt a fresh blow, with oil prices hitting nine-month highs overnight as traders reacted to the escalating tensions over Iran's nuclear program.

The European benchmark ICE Brent crude oil rose by close to 1 per cent to just under $US123 a barrel. Brent prices have now climbed by almost 10 per cent this month (or around $11 a barrel).

On the New York Mercantile Exchange, light sweet crude oil futures for April delivery climbed slightly higher to $106.28 a barrel overnight. The price of Nymex crude has climbed by $5.54 a barrel in the past five trading days.

Traders are now anxious about a possible armed conflict with Iran after the chief United Nations nuclear inspector, who is investigating Iran's alleged atomic weapons program, said overnight that negotiations had reached an impasse.

Iran's supreme leader Ayatollah Ali Khamenei pledged that Iran's nuclear work would continue, after UN inspectors left Tehran. "The Iranian nation has never been seeking an atomic weapon and never will be”, he said.

On the weekend, Iran responded to the European Union's embargo on oil purchases, which is due to take effect mid-year, by cutting supplies to French and British companies, and threatening similar punishment for others. Although the move was seen as largely symbolic as both nations import virtually no oil from Iran, it increased the level of anxiety in the market.

The escalating geopolitical tension comes at a time when the oil market is grappling with supply issues. South Sudan, which is in a dispute with Sudan over transit revenues, has shut down production, while a strike at Yemen's largest oilfield has also caused output to largely dry up. Syrian exports are affected by European Union sanctions, and Libya has yet to recover to its pre-civil war levels of output.

At the same time, prices are being supported by strong demand from China and from former Soviet bloc countries. Although Russia has pushed its oil production to post-Soviet highs, its actual exports have fallen, because of growing domestic oil consumption.

Analysts point out that Opec, and particularly Saudi Arabia, could step up production to make up the shortfall. But Saudi Arabia is already pumping oil at the highest rate in nearly 30 years, which means that spare capacity is low.

There are fears that the growing tensions with Iran, combined with the shortfall in oil supplies, could push oil prices to above the record high of $150 a barrel which was set in July 2008.

But even if oil prices remain at their current levels, 2012 would still represent a record year. Brent averaged $109 a barrel last year, well above the previous average record of $98.4 a barrel in 2008.

Economists warn that rising oil prices pose a major risk to the global economy. A sustained rise in the oil price will crimp corporate profitability, and fan inflationary pressures, which could cause global central banks to pull back from the ultra-easy monetary policies that they are currently running. At the same time, demand will dwindle as consumers will be forced to spend more to heat their houses and run their cars, leaving them with less to spend on discretionary items.

The effect will be even more disastrous for Europe, because of the weakness of the euro and the sterling. In terms of sterling, oil prices are now at an all-time high. In terms of the euro, the oil price is at a three-year high, just slightly below the record set in mid-2008. The surge in the oil price, economists warn, will likely drag Europe further into recession.