The Fuse

The Impact of the Federal Reserve on Oil Markets

by Matt Piotrowski | March 29, 2016

OPEC policy, fresh data from agencies such as the IEA and the EIA, price speculators, and geopolitical disruptions are all known as market movers. But there’s another important player in oil price movements, and that’s the Federal Reserve.

With oil and other markets so sensitive to a variety of headlines, any comments or action from the U.S. Fed or other central banks will have outsized effects on prices, for both the short and long run.

With oil and other markets so sensitive to a variety of headlines, any comments or action from the U.S. Fed or other central banks will have outsized effects on prices, for both the short and long run. A strong example was provided Tuesday, when U.S. Fed Chair Janet Yellen said that the bank would proceed cautiously on raising rates. Markets interpreted her remarks as dovish since economic concerns will keep the Fed from being as aggressive as originally expected with rate hikes. That is a supportive development for oil since lower interest rates weaken the dollar and keep borrowing cheap for speculators. NYMEX West Texas Intermediate (WTI) firmed on her comments—although they may not be enough to lift prices significantly given the current supply overhang.

Rate increases are still on the table for some point this year, however. Yellen was silent about the Fed’s meeting at the end of April and also noted that developments haven’t “materially changed” since December, when the Fed raised rates for the first time in almost a decade. Any rate hike would be a bearish development for oil, given that supply-demand fundamentals have yet to shift.

Fed action, or course, isn’t inevitable given current economic wobbliness. The irony regarding Fed policy is that sometimes bad news is good news for investors. Whenever poor economic data keeps interest rates low, investors cheer that as a bullish signal. The S&P 500, for example, shot up during Yellen’s remarks Tuesday, despite her repeating the different risks the global economy faces.

Recent Fed action

Speculators and other financial investors in oil and other markets have for some time closely eyed central bank actions when taking positions, a key contributor to rapid price swings and overall uncertainty. Just recently, for instance, the market has seen how much of an effect the Fed can have on financial players and the overall direction of oil prices. After the U.S. Federal Reserve raised interest rates by a quarter point in mid-December, oil fell by $11 in a little over five weeks, contributing to the weakest beginning of a year the market has ever seen.

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While this fall occurred against the backdrop of weak supply-demand fundamentals, the magnitude of the decline stemmed from the Fed interest rate hike—even though it was highly anticipated. The interest rate hike spurred uncertainty in stock markets, which in turn hurt oil. It also pushed the U.S. dollar higher for a month and a half, undermining oil prices, as the two have an inverse correlation. At the same time, speculators piled on the short side of the market betting on prices to fall, exaggerating the move downward. For instance, from December 15, the day before the Fed increased rates, to January 12, the number of shorts in NYMEX WTI exploded by 34,350 lots, or 21 percent, the equivalent of 34.35 million barrels of oil.

While the price fall occurred against the backdrop of weak supply-demand fundamentals, the magnitude of the December-January decline stemmed from the Fed interest rate hike—even though it was highly anticipated.

On the flip side, the Fed’s recent decision on March 16 to punt on raising rates again underpinned prices. The oil market rebounded in mid-February off its low of $26.21 on the back of a technical rebound, short-covering, and OPEC and non-OPEC producers discussing “freezing” production. But renewed bullish sentiment from talk that the Fed wouldn’t increase rates in the short term also played a role. In fact, NYMEX WTI soared by more than $4, or 10 percent, to above $40 in just three trading sessions (March 16-18) after the Fed decided to hold steady.

It’s not just the U.S. central bank that has had a big influence on prices. The European Central Bank (ECB), during the second week of March, packed a bullish punch by cutting interest rates and making more bond purchases—another clear example of how much the oil market hangs on actions by central banks. However, that wasn’t bullish enough—comments made by ECB President Mario Draghi suggesting that further rate cuts were unlikely dampened the mood. The differing assessment of news out of Frankfurt that day helped cause Brent crude oil prices to whipsaw around in a 3.3 percent range in just one session, further adding to today’s volatile climate.

Quantitative easing, and easy money

The past few months provide just some examples of central banks’ effects on oil prices. Back in early 2009, during the greatest financial crisis since the Great Depression, the central bank embarked on its quantitative easing (QE) program—or buying back bonds to bolster the economy—and zero interest rate policy. The stimulus pumped up all asset classes, including commodities, and made borrowing cheap for investors and gave them an easy one-way bet on oil. Of course, physical demand picked up as the recession eased, OPEC cut production, and a string of outages occurred in major producing countries, but three rounds of QE—along with its “Twist” to lower long-term rates—helped lift prices from the $30 range to triple digits from 2009-14.

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In 2014, oil prices crashed coincidentally at the same time the U.S. Fed unwound its bond buying program—described as “taking away the punch bowl.” QE, which expanded the Fed’s balance sheet by a massive $3.5 trillion, ended in October 2014, when oil prices were in the $80-$90 range and on their way to much lower levels. While the Fed was tapering its bond purchases in the summer and fall of 2014, investors fled the oil markets, with net length—those betting on higher prices—falling from more than 356,000 lots in mid-June when prices reached their peak for the year to just under 168,000 by the beginning of November and before the seminal OPEC meeting. That massive selling among speculators accelerated the price fall.

In 2014, oil prices crashed coincidentally at the same time the U.S. Fed unwound its bond buying program—described as “taking away the punch bowl.”

Of course, the collapse in oil prices was driven by a broad range of factors, not least the massive supply glut driven by non-OPEC supply, a global slowdown in oil demand growth, and the decision by OPEC and Saudi Arabia in particular not to cut production in November 2014.

There’s no way of perfectly knowing whether prices were driven more then (or at any given time) by supply-demand factors or speculation, but the Fed’s ending its stimulus contributed to the whirlwind of market forces during the second half of 2014.

Financialization is here to stay

None of this commentary is to say one factor (production levels, inventories builds/draws, OPEC policy, demand growth, Fed decisions) takes precedence over others. But financial plays based on monetary policy are, in many cases, just as important as physical fundamentals—since 2009, stimulative measures such as low interest rates and bond buying from the Fed have allowed exchange-traded funds such as the U.S. Oil Fund, commodity indexes, high-frequency traders, and hedge funds to pour money into the oil markets, giving these players an outsized impact on prices and volatility.

Financial plays based on monetary policy are, in many cases, just as important as physical fundamentals.

Whatever the case, speculators will continue to contribute to oil market fluctuations. The following quote from a United Nations Conference on Trade and Development (UNCTAD) report on the financialization of commodity markets sums up their actions very well.

“These investors treat commodities as an asset class, which means that they are betting on a certain price trend during the period they are invested in commodity assets,” the report said. “They do not trade systematically on the basis of fundamental supply and demand relationships in single markets, even if shocks in those markets may influence their behavior temporarily. In general, however, their decisions to buy and sell are rather uniform (herding) and are driven by the same kind of information that is available for other financial markets.”