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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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What Would Negative Interest Rates Mean for the Oil Market?

The dour economic environment is continuing to resist the best efforts of policy makers and central bankers around the world. The latest evidence of just how tough it is proving to move the global economy above a stall speed came a few weeks ago when Japan announced negative interest rates in an effort to boost its still flagging economy.

Negative interest rates are essentially fees that companies are required to pay in order to hold cash with banks. Similarly, banks can be charged fees for holding cash with the Central Bank. What makes negative interest rates so interesting is that the world has never seen a period of widespread negative rates in recorded economic history. As a result, the exact effect of such rates is somewhat unclear. Related: U.S. Unable To Halt ISIS March Towards Libyan Oil

In theory, negative rates should lead banks to be willing to lend funds to creditworthy borrowers at even lower levels, and companies should be more willing to spend and invest cash. That’s just theoretical though. The reality is that banks are never going to actually pay people to borrow money from them (i.e. true negative interest rates), and companies will only invest money in projects that they think are profitable. That is the challenge for oil companies in a negative interest rate environment.

Oil companies are suffering right now, not from lack of access to capital, but from lack of economical projects to invest in. At current oil prices, there are virtually no fields that make economic sense to develop. As a result, negative interest rates are unlikely to boost oil supply further. Related: Is This The Most Bullish News For Oil Since 2014?

That said, negative interest rates could have two possible effects on oil companies. First, negative interest rates could hurt oil companies if banks begin to charge the firms for access to capital and holding liquid cash and securities. Right now, many oil companies are looking to ensure they have plenty of cash to ride out the on-going storm. New capital spending and investment is the furthest thing from their minds. To the extent that maintaining this liquidity becomes more expensive, negative interest rates could further exacerbate an already bad situation for oil companies.

Second, negative interest rates might play a role in helping to boost the flagging global economy and rekindle demand for oil. This is very speculative. The effectiveness of monetary policy at zero interest rates is often compared to pushing on a string. Related: Oil Price Volatility And Market Predictions

Still, if policy makers can figure out how to effectively implement lower rates in the weaker economies of the world like Japan, then it could help to provide a global boost. This will require creativity and commitment, but so far those are qualities the new Japanese Central Bank has in spades. Even as the U.S. is starting to raise rates, Japan, Europe, and China are all still in a weak or even decelerating position. If negative interest rates can offset these ill effects, then it should help oil companies.

There are a lot of unknowns related to negative interest rates, and certainly no one can claim to understand all the ramifications for what is largely an unprecedented experiment. There are dangers for oil companies especially those that need to hold cash for liquidity purposes, but if negative interest rates can do anything to boost the global economy, then they will ultimately do far more good than harm for oil prices.

By Michael McDonald Of Oilprice.com

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