Oil and Interest Rate Uncertainty Makes for an Interesting Couple of Weeks

The next two weeks promise to be interesting on a couple of fronts. First off, oil prices may – and I repeat – may be headed for a holding pattern until a few things play themselves out. Don’t get too excited as this may be nothing more than a bit of a price hiccup as the world grudgingly accepts that we will not likely again see oil under $130 a barrel.

Much of the indecision in the market stems from very strong hints being floated by Federal Reserve Chairman Ben Bernanke that continued interest rate cuts are about to be reversed as inflation worries grow. Even the European Central Bank and the G8 finance ministers have added “global inflation” as an agenda item increasing the likelihood that we are entering a new phase of interest rate increases to keep inflation at bay.

The Bank of Canada was first off the mark last week and surprised more than a few on Tuesday when it held the line on its overnight target rate keeping it unchanged at 3.00% and the Bank Rate at 3.25%. Many expected a rate cut of 0.25% following four consecutive rate cuts dating back to December 2007.

Bernanke followed the Bank of Canada announcement with a speech at the Federal Reserve Bank in Boston where he argued that inflation concerns are beginning to trump liquidity problems in the U.S. economy. The subprime mortgage problems have dominated the Fed’s efforts for the past year resulting in several programs aimed at propping up the banking industry, but higher energy costs have pushed inflation to cautionary levels and Bernanke left little doubt that the Fed will aggressively tackle inflation suggesting that, for now at least, interest rate cuts are off the table:

“The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations”, Bernanke noted in a speech on June 9th. “The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.”

Inflation in the U.S. has increased by 3.2% since April of 2007 despite the weakness of the greenback. With Bernanke publically focusing on inflation, and with the next Federal Open Market Committee (FOMC) meeting scheduled for June 24th, it seems likely that the Federal Reserve hawks are preparing to hike rates.

Bernanke and Bank of Canada Governor Mark Carney were not alone last week in hinting at inflation concerns. The G8 finance ministers – just wrapping up their meeting in Japan – also discussed how inflation is impacting their economies. Again, the blame has been laid at the feet of world oil prices together with the weak U.S. dollar which is used to price oil. Most of the G8 countries are net importers of oil and the continued struggle of the dollar only compounds the cost to import oil and associated refined products.

Japan’s Financial Services Minister Yoshimi Watanabe was quoted as saying that “defense of the dollar has become an urgent issue” while the Italian Minister of the Economy – Giulio Tremonti – suggested that a plan to curb oil speculation was needed to avoid an “impoverishment of the middle classes” which if not curtailed, could only lead to “fascism”.

Despite the rather dire and heavy-handed warning offered by Tremonti, it is a fact that speculation and the weak U.S. dollar are partly responsible for the record oil prices, and this combined with a growing demand primarily in India and China account for today’s prices. OPEC has consistently refused to increase production despite the 300,000-barels-a-day Saudi Arabia added in May and the 200,000 extra it has promised for July.

These amounts are – quite literally – a drop in the bucket and the first increase did nothing to slow oil’s ascent. 200,000 barrels adds barely a 2% bump to Saudi Arabia’s production and will not impact supplies in any meaningful manner whatsoever. However, Saudi Arabia has asked for a meeting of the OPEC producers for June 22nd to discuss oil prices which Saudi Minister of Petroleum and Natural Resources Ali al-Naim simply described as “too high”. An OPEC spokesperson has since stated that no discussion on production increases will take place prior to OPEC’s scheduled meeting set for Vienna on September 9th.

Some readers may recall that Saudi Arabia has broken ranks with OPEC solidarity in the past. During the 80s and 90s and fearing a consumer backlash, Saudi Arabia unilaterally increased production forcing other producers to follow suit in order to remain competitive. Saudi Arabia deliberately drove world prices down over fears that its customers would find ways to reduce dependence on oil, thereby shrinking demand for oil permanently – perhaps even accelerating efforts to find alternative sources of energy.

This would be disastrous for Saudi Arabia – it’s only real source of income is the exportation of oil and in order to maintain the level of prosperity to which the kingdom and it’s people have become accustomed, a strong market for its oil is fundamental. Does this apparent willingness to increase production to reduce world prices signal a change in production quotas for other oil producers? Time will tell, but as the most “U.S.-friendly” of the OPEC nations, this call to increase production may simply be an attempt to ease the pain which the U.S. economy is currently facing and ensure a long and prosperous (for Saudi Arabia at least) addiction to oil.

The other point of interest goes back to the value of the U.S. dollar. If the Fed follows through with interest rates hikes, this will strengthen the dollar on the forex markets. Because oil is priced in American dollars, this could make oil more expensive for those importers forced to convert native currency to U.S. dollars, and if the greenback maintains a prolonged rally, this could result in a reduction in demand for oil. This in turn may lead to lower oil prices as it will cost more to convert to U.S. dollars; also, those that have been buying oil futures to hedge a weak greenback may start to divert some of those dollars to U.S. fixed income instruments thus lowering the demand for oil as a speculative investment.

The picture surrounding oil prices and interest rates will be much clearer in the next two weeks and much of what happens depends on the next rate announcement by the Fed on June 25th. Despite what takes place however, do not expect a huge drop in the price of oil any time soon so don’t trade in the little gas miser you just bought to get your old SUV out of hawk. There will be no significant rollback in prices but enough uncertainly may creep into the markets to keep prices holding steady for the short term at least.

About the Author

Scott Boyd has been working in and writing about the financial industry since the early 1990s. As a technical writer and project manager with several of Canada’s leading financial institutions, Scott has produced educational materials for investment system end-users including portfolio managers and traders. Scott now administers and contributes to OANDA FXPedia and regularly provides commentaries for the OANDA FXTrade website.

This article is for general information purposes only. It is not investment advice or a solicitation to buy or sell securities. Opinions are the author’s — not necessarily OANDA’s, its officers or directors. OANDA’s Terms of Use apply.