What Today’s Fed Decision Means for Oil Prices
After nine years of historically low interest rates, the Fed is finally getting ready to remove the proverbial punchbowl from the easy-money party.
As it stands, Yellen & Company are only contemplating a mere 25 basis rate hike and even that now seems unlikely.
According to the CME Group’s FedWatch tool, the Fed Funds futures contracts are pricing in a below 25% chance of a rate hike later this afternoon.
And while I agree that the Fed will likely hold off, I wouldn’t be shocked if they pulled the trigger, given the strength of the labor market.
And when it comes to oil prices, the projections of doom and dread are now running rampant. Here’s why they’re wrong…
The Irrational Frenzy Surrounding the Fed’s Decision
Rarely has a decision by the Federal Reserve engendered such a frenzy among market analysts and investors.
But let’s be honest here. Any hike isn’t likely to exceed 25 basis points (0.25%) and will be a stand-alone. This is hardly going to be the breach in the dam that results in a series of increases unfolding every month or so.
And bond markets have already factored this in, with rates across the board rising much beyond the projected Fed move.
Still, there is the emotional reaction to the hike and that is certain to inject another bout of volatility.
This is a matter of concern for other markets.
While you are reading this, my schedule calls for me to be flying back to the United States. Conversations I’ve had in several of the European countries where I’ve been over the last ten days touched upon the Fed decision.
What’s interesting to me is that most of my contacts would prefer the Fed to just get it over with. A move sooner rather than later would allow the effect to occur and then markets to adjust.
Remember, as the U.S. prepares to leave central bank manipulation of fixed income issuances, Europe, China, and others are embracing economic stimulus as well.
That contrast could exacerbate the market’s reaction to any interest rate hike.
The Short-Term Effects of a Rate Hike on Oil Markets
The presumption is that a rise would put immediate pressure on crude prices by making purchases more expensive in foreign markets.
This is because a rise in rates results in dollar-denominated bonds becoming more attractive, thereby increasing the exchange value of dollars against other currencies.
And that’s what will have the greatest initial impact on oil. Because the vast majority of oil sales worldwide are denominated in dollars, a rise in the dollar means it costs more in other currencies to buy a barrel of oil.
Conventional “wisdom” holds that this has an adverse impact on demand. All other things equal, there may be a change, even if short-lived.
Demand, Not Interest Rates, Will Determine Long-Term Energy Prices
However, the real effect on demand centers on what impact the rise in both the price of oil and the exchange value of the dollar will have on a range of economic matters.
In this respect, the broader usage of energy (beyond simply that of oil) will be at issue. Market demand for all manner of energy will ultimately be determined by genuine demand, not by stimulated usage from lower prices.
After all, almost without exception, depressed prices (such as we’ve experienced in spades during the past several months) tend to increase the use of energy. And as energy becomes cheaper, end users increase consumption.
But the real impact will be felt across a broader range of commodities – metals, processed products, natural gas, even electricity traveling across borders.
Yet in all, this will be quite manageable, with the negative impact of any interest rise in my view greatly overestimated.
What will take a bigger hit are the artificial pressures that have been distorting the actual market rates for oil. Here the hyped short selling and multiplication of derivatives through which manipulators have artificially made profits from a crude dive will be distorted.
That bubble will be more pronounced, but that is going to be a problem primarily for those who created it.
That’s karma for you…
Now, the important point to remember is this: Energy demand elements are emerging that far outweigh the significance of any Fed move. Because while the fixation on a rise in interest rates continues, aggregate expected global oil demand is moving up regardless.
Both the International Energy Agency (IEA) in Paris and the OPEC Secretariat in Vienna are poised to yet again raise year-end 2015 oil demand figures.
The current forecasts are already high, with the IEA predicting that global oil demand this year will average 94.2 million barrels per day, 1.6 million more than last year.
For next year, the IEA is forecasting 95.6 million barrels per day.
And supply won’t be able to keep up with rising demand. Global oil supply, mostly from non-OPEC producers, fell by 600,000 barrels per day in July.
So regardless of what the Fed decides, the fundamentals paint a picture of tightening oil supply at a time of increasing demand.
That will be where the real long-term pricing of oil is going to be determined. Because as long as the world demands energy – and those demands are increasing – the energy sector will prosper.
And we’ll find ways to make money.