Why “Deleveraging Markets” Will Drive Up Oil Prices

by | published June 24th, 2013

The reality is sinking in all over the globe. Federal Reserve policy is about to change.

It won't be immediate, but it is clear the days of QE are drawing to a close.

Traders have always known that it couldn't go on forever. They just seemed to think it was going to be the proverbial mañana.

And in some ways that is true. The Fed has not done anything yet and will not apply the brakes to bond purchases until at least the middle of next year.

No matter, the crowd is still rushing out the door-especially in the bond markets, where interest rates continue to climb.

I have addressed that matter quite recently right here in OEI (Why the Fed's QE is about to Move Oil Prices, June 14, 2013).

As I noted then, as the interest rate rise, so will oil prices…

Oil Prices and Interest Rates

This is initially a knee-jerk reaction to inflationary fears. Quite apart from other driving forces (demand spikes, regionally-specific supply constrictions, as well as rising extraction, processing, and transport costs, for example), the interest rate situation will push up oil prices.

That means those stocks having a rather direct connection to the price of crude will be moving up as well.

But, as is the case in all moves like this, the rising tide will not raise all boats-at least, not to the same level.

It is still decisive for investors that companies have correct positioning, a well-structured approach to their primary focus in the upstream-midstream-downstream continuum, and sufficient cash flow.

This last aspect-sufficient cash flow-is important.  Because there is another way in which higher interest rates will impact oil prices.

Here, the emphasis is on paper, not wet barrels.

The Fallout from Fewer Paper Barrels

Paper barrels refer to the futures contracts on crude, while wet barrels address the oil being delivered. On any given day, the volume of paper barrels significantly outweighs the actual amount of oil shipped.

Futures contracts are made for deliveries months or even years in advance. The heaviest action is on the nearer end of the curve (one to six months out), with options taken to offset risk. That merely adds to the amount of derivative paper surrounding each eventual shipment of physical product.

Now many of these contracts simply cancel out before expiration, while options are exercised to offset contract losses in others. All of this requires the availability of considerable capital.

And that brings us back to additional fallout from interest rate increases.

Over the past year, as the Fed has been purchasing $85 billion in bonds each month, the low interest rates that resulted have allowed for massive borrowing at low rates in the American market to finance projects and acquisitions, often located elsewhere. The U.S. bond market, in short, has been the source of low-interest funds.

This is ending and with it the leveraging that has taken place.

Capital realized from playing the interest game has been used across the board. But a widening amount of it has been finding its way into derivatives on commodities.    

The reason is rather straightforward.

For the past several years, gold, silver, and oil have become the primary “stores of market value.” Futures contracts, commitments on later deliveries of these commodities, rose in consequence with the upward movement in markets overall.

However, the recent collapse in gold and silver prices has prompted a move to oil as the barometer of overall market value (see Why Oil is Becoming the New “Gold Standard,”May 20, 2013). As such, the use of futures contracts in crude has been morphing to reflect that new role.

The ability to leverage cheap American interest has been fueling the application of futures. However, unlike the expected result of increasing prices, the recent usage has actually served to restrain the upward movement in oil's market value.

That is because large amounts of these new contracts have been made to short crude.

Such activities are actually rather complicated. But stated simply, the assumption among traders using this approach has been to regard the market recovery as being tempered by widening concerns over continued Chinese growth.

That bet may have some credence, although my personal opinion is to discount it as a major driver of movements in the energy sector. China will continue to expand, albeit perhaps at a slower pace. Nonetheless, recoveries elsewhere will temper that impact.

In normal circumstances, the employment of cheap credit to fuel an ongoing short play restraining the advance of oil would expand. The aftermath of the Fed telegraph last week, on the other hand, has rendered this approach less palatable.

As a result, we will be seeing market factors themselves having more to say about the direction of oil futures.

Higher Oil Prices Ahead

Those factors are now turning upward, as a combination of demand increases, a reduction in U.S. surplus oil in storage, and renewed geopolitical uncertainty apply upward pressure.

We were seeing this play out before the aftermath of the Fed last week. Today, we are likely to have another smaller decline, but more owing to the renewed (over baked) cautions about China.

However, the extent of bets that oil prices will decline will be restrained by the new reality of more expensive credit on the horizon. Remember, the impact of these shorts has been in the six-month to one-year section of the curve.

And that cut is going to be hit by higher interest costs moving forward.

There will still be short moves and the price of oil will hardly be moving up uniformly.

But the days of artificial depressions in oil prices are drawing to a close.

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  1. ronald g oconnor
    June 24th, 2013 at 13:02 | #1

    “a short play” ? How much of a short play has been going on with prices moving up slowly but steadily? This “short play” seems to have been a consistent money looser for shorts! Nonsensical!

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