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If anything underscores how geopolitical forces have played havoc with oil prices, it's the latest armed conflict in the Middle East, pitting the Israeli military against Hezbollah guerrillas in open warfare in Lebanon.
Already heightened by the U.S.-led confrontation with Iran over its nuclear ambitions, fears about the stability of oil supplies have only increased since the Gaza bombings earlier in July and have intensified sharply as Israel targets Lebanon. The outcome is now even more uncertain than it appeared to be just a few weeks ago. How long the conflict continues-and whether it spreads to surrounding countries-will determine the future of energy prices, at least in the short run. With Iranian President Mahmoud Ahmadinejad saying on July 25 that the fighting could trigger "a hurricane" of a broader war in the Middle East, the prospects look dire to many observers-especially oil traders-around the world.

Having survived higher energy prices relatively unscathed so far, the U.S. economy is more sensitive to costlier oil now than it was a year ago. Inflation, even excluding energy, has accelerated, leading the Fed to raise interest rates 425 basis points in response. Consumers are already spending more than they earn. And Standard & Poor's expects the economy to slow down to a 2.5% GDP growth pace in 2007 from an estimated 3.5% in 2006. The falloff in U.S. growth means it takes a smaller shock to cause a recession than it did a year ago. Continued strong world oil demand, with usage in both China and Europe accelerating, will continue to put rising pressure on oil supplies despite a U.S. slowdown, thus raising the odds of an oil price surge causing a U.S. recession.

Whether the current Mideast conflict causes a recession depends mostly on how big the impact on oil supplies and prices becomes. This is still highly uncertain. At Standard & Poor's, we continue to believe that the most likely outcome is that cooler heads will eventually prevail and that oil prices will drop back from current peaks. The range of worse outcomes, unfortunately, is almost unlimited. We've looked at four scenarios, but even worse cases, or combinations of the problems below, are also possible:

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* David Wyss is Chief Economist with Standard & Poor's, New York.