What The ECB Actions Mean For Oil

In case it escaped your attention, Mario Draghi, the ECB President, announced a package of measures yesterday designed to stimulate the lagging Euro zone economies. To many energy investors who focus on WTI and maybe natural gas prices and the stocks of companies involved in those industries that may seem to be of marginal importance at best, or irrelevant at worst. My dealing room experience, however, taught me that all financial markets are inextricably linked. Developing an informed opinion as to the prospects for any one market requires an understanding of others. The ECB announcements, therefore, will have a profound effect on the energy markets in the future.

The package Draghi announced yesterday was, particularly for the ECB, quite aggressive. They will be increasing the size their bond buying program, their version of QE, by one third, from 60 Billion Euros a month to 80 Billion and that program is now slated to continue for longer. They cut their main interest rate from 0.5% to 0% and the bank deposit rate from -0.3% to -0.4%, as well as announcing an innovative policy that will actually pay banks to borrow money and lend it out. All in all it amounts to some serious monetary stimulus.

Still, if you believe the immediate reaction of markets yesterday, it wasn’t enough. The initial reaction, a drop in the Euro and a surge in European stocks, was what one would have expected, but as Draghi spoke in the ensuing press conference and said that he didn’t envisage the need for further rate cuts the markets turned. A quick look at the inevitable effects of the policies and the one historical precedent, however, indicates that the initial reaction was correct and a lower Euro and stronger European equity markets are on the cards for the foreseeable future.

QE is effectively about creating money and handing it to the banks in the hope that they will lend it out and thereby encourage investment. The problem is, though, that without accompanying fiscal stimulus, banks don’t necessarily see loans as the best way of investing the money that is forced upon them. With ultra low interest rates, the return from equities looks far more appealing. That leads to a growing pool of money chasing a limited amount of paper and that in turn pushes stock prices up.

At the same time, simple supply and demand suggest that increasing the supply of Euros at a rate of 80 billion a month for an extended period devalues the currency. Short term expectations may have dominated the initial reaction, but over time the most basic relationship in economics must have an effect.

If you look at the immediate reaction to yesterday’s announcements and believe that the premise of a lower Euro is faulty I would simply suggest that you look at what has happened in Japan since the advent of so called “Abenomics” in Japan in 2012. When Abe won the election there and the prospect of negative rates and huge QE became real the Yen at first reacted little. As the policy took hold, however, USD/JPY climbed, meaning that the Yen devalued, by over 33%.

(Click to enlarge)

Assuming that over time the same forces will create a similar impact on the Euro, it is that projected weakening of the currency that stands to most impact energy investors. A weaker Euro means relative dollar strength and that, in turn limits the upside for commodities, including oil. The ECB’s actions may not, at first glance, seem to directly impact the oil market, but over time they will most likely be one more contributor to the “lower for longer” phenomenon that many expect.