How The Fed Is Artificially Propping Up Oil Prices

0
55

By Nick Cunningham

Oil prices have stabilized at $40 per barrel, despite global oil demand remaining sharply below pre-pandemic levels. Everyone knows the significant role that OPEC+ has played in balancing the oil market, along with the sharp drop in production elsewhere, including in U.S. shale. But looking further out, another institution could play an even larger role in driving up oil prices: the U.S. Federal Reserve. Oil prices have historically moved in close concert with inflation. Recent examples include 2003-2008, which saw loose monetary policy, inflation and an incredible run up in crude oil prices. After the financial crisis, the Fed took extraordinary action to revive the collapsed economy – and crude prices shot up between 2009 and 2011.

There are multiple links between Fed action and crude prices. The inputs – labor, land and raw materials – all increase in price with inflation. When those costs rise, that makes production more expensive. Oil is also critical to the economy, so any upswing in the economy tends to lift crude as well.

According to Raymond James, which published a report on the link between inflation and oil markets, the correlation with oil and inflation may only magnify going forward for two reasons. First, the steep decline rates of U.S. shale mean that production will only increase when drilling activity ratchets up – and activity won’t return until prices are higher. Also, more generally, many companies cannot turn a profit under current conditions, so prices will likely need to rise.

However, the Fed plays a more direct role. The “monetary bazooka unleashed by the Federal Reserve in response to the coronavirus pandemic is unlike anything we have ever seen in our history,” Raymond James analysts wrote in a note. During the global financial crisis, the money supply increased 13 percent between December 2007 and July 2009, equating to a compound annual growth rate of 8 percent. “Just in the first six months of this year, the money supply is up 20% or growing at a whopping 47% CAGR!” the analysts exclaimed.

The effects have already been plainly evident. In the last few months, the stock market has soared even as tens of millions of people lose their jobs and thousands of businesses go under. More pain surely lies ahead with a tidal wave of evictions looming. Somehow, stocks are doing just fine. The Fed deserves much of the credit (or blame).

But inflating financial assets cannot go on forever. It “will eventually go into general circulation pushing up labor, rent, and food prices,” Raymond James added.

And, of course, crude oil. In other words, the bazooka of money supply will lead to more inflation, the investment bank says, which will drive up crude prices. That would ultimately work in favor of the oil industry, and perhaps bail out companies drowning in debt.

On the flip side, more inflation would mean that interest rates will also have to rise. Higher costs of capital would threaten the ability to refinance the existing debts of struggling oil companies, and expansion plans overall would be more costly.

Raymond James says that the indebted oil companies that have maturities far out into the future will come out ahead of others with more immediate concerns. Those companies can benefit from the updraft of higher prices without necessarily worrying about higher interest rates. For those facing a wall of short-term debt, the hope of another boom cycle at some later date is of little help today.

The bottom line is that the trillions of dollars injected into financial markets by the Federal Reserve increases the odds of higher inflation, the report argues. Fending off anticipated criticism about the recent history, which has seen a surprising lack of inflation at nearly every turn, Raymond James says that “this time is different.” The magnitude of the increase in money supply in the past few months dwarfs what happened a decade ago.

Crude Oil

LEAVE A REPLY

Please enter your comment!
Please enter your name here