The Federal Reserve's Impact on Oil Prices

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If the panel increases the interest rate banks charge each other at its June 14-15 meeting, it would be only the second hike since the end of the global recession, and the value of the U.S. dollar on global markets would rise. In response, the price of many valuable commodities, including gold, pork bellies and especially crude oil, would likely fall, perhaps dramatically so.

On the other hand, if the Fed decides not to hike interest rates this month, as now seems likely, oil prices may very well rise.

So why does a decision by a dozen central bankers in Washington, D.C., directly influence the price of each barrel of oil produced every day around the world?

The reason is both complicated and straightforward. Increasing interest rates in the current global environment will make U.S dollars more attractive as an investment, which in turn boosts the price of a dollar against other currencies.

“If the dollar is stronger, it really shows that this is the era of speculative trading, traders, hedge funds; this is not commercial users driving the oil price higher right now,” Tamar Essner, NASDAQ’s energy director, told CNBC earlier this month. “The dollar will really be an important determinant where fund flows go, which will set the trajectory of oil prices, at least over the next six months.”

And because crude oil around the world has been priced in U.S. dollars for decades, every barrel of oil purchased in a non-dollar currency becomes slightly more expensive as U.S interest rates go up. The same thing would happen in reverse if U.S. interest rates would go down, something that hasn’t happened since 2008.

While this general relationship – a stronger dollar means more expensive oil for non-dollar economies -- has existed for many decades, only in last decade or so have hedge fund traders and investment managers changed the way oil and currencies are traded via futures markets.

This trading phenomenon – called reverse correlation – between the U.S. dollar and crude has essentially allowed traders and bankers around the world to turn crude oil into a financial instrument all its own, making it no different than stock or bond investments.

This means that at any given moment during a trading day, the odds are often above average that if crude oil is going up, the U.S. dollar is going down, and vice versa. While there is increasingly strong academic evidence of this trading relationship, authorities are still unsure whether it qualifies as unfair speculation, and can’t tie higher energy prices to its behavior.

Big investors make this trade to better protect against the risk of a major downturn in the global economy, but when you hear criticism of speculators and Wall Street types concerning oil futures markets, this use of oil as an investment, rather than simply as a fuel used by billions of low-income people, is often the root complaint.

And as it turns out, the odds of the Fed raising interest rates have fallen dramatically in the past several days, as last week’s May’s U.S. employment report citing the creation of only 38,000 jobs is one of the worst economic signals in years.

Fed watchers put the chance of an interest rate increase next week at only 4 percent, compared to 34 percent before the jobs announcement. And as a result, oil markets are unlikely to react unless a surprise occurs.

The chances of an interest rate hike by the Fed in July is higher – 34 percent -- which means observers will have one more chance this summer to see whether the reverse correlation still has an outsized impact on oil.

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