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Long-Term Implications Of Fed Action Could Backfire On Oil

FED

There are many things about my career in interbank forex for which I am thankful. I can swear in multiple languages for example, and feel only amused when I see others in apoplectic rage. I can also still drink a lot without falling over, and hold a conversation while listening to two other things. There are also some more practical lessons that I learned, including that too narrow a focus on the news about one market is not a good idea. That seemed to be the case in energy this week, when the thing that was the focus of most other markets, the conclusion of the FOMC meeting and subsequent statement and press conference was largely ignored.

The energy markets are never short of industry specific stories, but sometimes it is what is going on in the background that sets the overall tone for the long-term, and that is the case this week. So it happened that at about the same time as Fed Chair Janet Yellen was holding a press conference the Kuwaiti oil minister was telling the world that compliance with the production cut deal was at one hundred percent, or even more, and inventory numbers were due out shortly thereafter. Oil futures traders chose to focus on oil-specific stories, but the intentions of the Fed have greater long-term implications for the market.

What the statement following the meeting and Yellen’s subsequent comments at the press conference told us was that, despite some misgivings about the strength of the U.S. economy, the central bank was still set on a rate hike in December and was still going to embark on the massive task of reducing its bloated balance sheet. That initially involves only not replacing bonds that mature rather than actually selling into the market, but essentially removing a huge buyer from the bond market will have a similar effect; it will depress prices and therefore put upward pressure on rates.

There are many reasons why taking a chance like that can be justified. However, for an oil market that is still oversupplied but has rebounded on an improving demand outlook it represents a real danger. Anything that threatens to keep U.S. growth at around two percent or even cause a temporary dip below that is bearish for oil, and that is what this decision suggests.

(Click to enlarge)

Oil futures, however, barely registered the Fed news, and waited for weekly inventory numbers later in the day before moving off the highs. That is understandable as most futures trading is speculative and short-term, but the rapid bounce back from that drop suggests an underlying strength that is harder to explain.

It must in part be due to the Kuwaiti oil minister’s comments, but as I have said in the past, OPEC ministers talking up the price of oil as a meeting approaches is neither a new phenomenon, nor is it particularly surprising… I mean, what else are they going to say? The fact is, though, that while the cuts have certainly helped, the supply issues are really coming from elsewhere. U.S. shale production is the biggest factor there, and in other news this week the EIA forecast that that will continue to increase. That leaves supply and demand for oil in the U.S. market, the largest in the world, precariously balanced. Tightening of any kind by the Fed could easily tip that balance.

It seems then, that the oil market’s focus this week has been on short-term factors, and news that potentially will have a large, lasting impact, is being shelved. Eventually, however, that news will come into focus. Last week I suggested a short position that turned out to be premature, but I will be trying again at these levels as a drop back to the mid $40s looks likely when that happens.




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