U.S. stocks started the short week in brutal fashion as the market focused its attention to the escalating violence in the oil producing nation of Libya.

Crude oil prices surged, exacerbated by reports that the nation halted more than 8% of oil production and exercised “force majeure,” a contractual clause freeing both parties of an oil contract from liabilities or obligations in light of an extraordinary event.  According to the Wall Street Journal, Libya produces 1.8 million barrels of oil daily, and its 41 billion barrels of proven reserves represent more than 3% of global supplies.  Currently, crude oil is trading at $96.14 a barrel in New York and $107.48 on the ICE Futures Europe exchange. 

Treasurys finished higher as the crisis in Libya and concern that Middle East instability could hurt the world economy sparked a flight to safety.  All ten S&P 500 sectors finished lower, with Utilities, Energy, and Consumer Staples declining the least.

Yesterday I pointed out that the VIX Index – a measure of stock market volatility – had reached worrisome levels that suggested complacency.   That all changed yesterday, as volatility spiked 27%, the most in nine months. 

The events in the Middle East have the potential to provide a shock to the global economy like that of Europe’s debt crisis last spring, particularly if the unrest continues to spread to bigger producers of oil and affects production.  High oil prices can be a big drag on economic growth as they squeeze corporate profits and act as a tax on consumers by shrinking their discretionary incomes. 

Oil prices can, of course, shift quickly.  Hints of resolution could send prices tumbling.  In the meantime, expect oil and stocks to exhibit an inverse relationship in the days ahead.

Market Activity for February 22, 2011

Sector Activity for February 22, 2011