The world can weather a spike in oil prices, U.S. President Barack Obama said, as Saudi Arabia offered some respite to fears over Middle East oil supplies by indicating it can cover export cuts resulting from Libya's civil war.

After a surge in Brent oil prices to 2-1/2 year highs near $120 a barrel, South Korea, the world's fifth-biggest crude importer, warned that its inflation situation was getting tougher.

Business executives fretted about rising prices and investment banks said oil was reaching an inflection point that could endanger the world's recovery from the global financial crisis.

"We actually think that we'll be able to ride out the Libya situation and it will stabilize," Obama, referring to fuel prices, told a group of corporate chief executives.

His Treasury Secretary said the world had plenty of oil reserves.

"We have substantial capacity across the major economies in the strategic reserves," Timothy Geithner said.

"Hopefully, by reminding people of that and calling attention to the fact that there's a fair amount of excess capacity in parts of OPEC ... hopefully that will make it less likely the market ... starts to build in higher prices over time."

The key risk for the world economy is a sustained rise in the price of oil. But after shooting up to close to $120 a barrel in intraday trade on Thursday, Brent crude futures ended the day at less than $112, showing just how fraught investors nerves are.

The sharp fall came after market rumours that Libyan leader Muammar Gaddafi had been shot dead and on news that top producer Saudi Arabia could cover any supply disruptions.

On Friday, Brent crude was trading around $112. U.S. crude futures eased to $97.60 from a Thursday high of $103.41.

In Libya, forces loyal to Gaddafi hit back in fierce gun battles with rebels holding towns near the capital but there were no signs they had broken the opposition momentum.

The Organization of the Petroleum Exporting Countries (OPEC) has an estimated 4-6 million barrels per day of spare crude production capacity, more than enough on paper to cover Libya's output of 1.6 million barrels a day.

But markets are worried that the unrest might spread to bigger producers in the region that would have a much bigger impact on the world economy.

After public uprisings have already toppled leaders in Egypt and Tunisia, governments in the region are taking notice.

Saudi Arabia this week unveiled a $37 billion package to try to insulate the kingdom from the wave of protests across the Arab world, while Algeria lifted a 19-year-old state of emergency as it tried to appease opposition groups.

"When you start adding the potential number of barrels at stake, you can see why the market is tense and would rather be long oil than short," said Harry Tchilinguirian, chief commodity strategies at BNP in London.

INFLECTION POINT?

Deutsche Bank said oil above $120 a barrel would be an inflection point for global economic growth. At that price, oil as a share of global GDP starts to move above 5.5%, historically a point where global growth has come under pressure.

Airlines are feeling the brunt of high oil prices as reflected in sharp falls in stock prices. Chinese flag carrier Air China Ltd has dropped 14% this week.

"Unfortunately, oil prices have been rising like mad recently," said Li Jiaxiang, head of the Civil Aviation Administation of China.

Emerging Asia, which led the world's recovery from the global financial crisis, is already trying to deal with escalating food prices. Higher oil prices will add to the dilemma for policymakers of how to contain inflation and support economic growth.

Yet another complication is that while the crude price spikes this week reflect a supply-side risk, oil prices were already rising as economic activity around the world picked up pace.

"The global recovery is ongoing, it is gaining more traction but the developments in the crude-oil sector as a result of the turmoil in the Middle East is putting to question the strength of that recovery," said Jose Mario Cuyegkeng, economist at ING in Manila.

Since most countries have little control over the world price of oil, raising interest rates would not address the issue for their economies. But higher fuel prices could feed through to other prices, such as transport, and inflation expectations.

"The environment influencing inflation is now much more difficult than what we had expected at the end of last year," said Yim Jong-yong, South Korea's vice finance minister.

Indonesian central bank deputy governor Hartadi A. Sarwono said he expects a recent drop in food and commodity prices to push monthly inflation down in the country, but oil was a risk.

"We have to be cautious on long-term inflation from rising oil prices," he told reporters.

The combination of high oil prices undermining growth while fuelling inflation raises the prospect of stagflation that blighted economies in the 1970s.

Westpac rates strategist Russell Jones said there was a risk of stagflation but there were economic differences now -- including less reliance on oil and better central bank credibility -- to suggest any outbreak would be mild and short lived.

Still, it would still result in a pick up in the pace of monetary policy tightening, he said.

"The longer that oil prices remain elevated, the more likely that the European Central Bank and Bank of England could hike in the second quarter. Emerging market central banks are also apt to tighten more aggressively.